Imagine the Federal Reserve's policy rate is 5%. Is that high enough to slow the economy? That depends partly on inflation. A 5% interest rate means something different when inflation is 2% than when it is 6%.
But inflation is only part of the picture. Economists also consider the neutral interest rate: the estimated rate at which monetary policy neither stimulates nor restrains economic activity.
For investors, the challenge is determining whether the Fed's current policy rate is actually restrictive, rather than simply judging it as high or low by historical standards.
How Inflation Changes the Meaning of Interest Rates
The Federal Reserve sets its policy rate in nominal terms, meaning the stated interest rate does not account for inflation. But when economists assess how restrictive monetary policy is, they also look at the real interest rate, which adjusts for inflation.
Consider a policy rate of 5% under two different inflation environments:
- If expected inflation is 2%, the approximate real policy rate is 3%.
- If expected inflation is 6%, the approximate real policy rate is −1%.
The nominal rate is identical in both cases, yet the real rate is very different. In the first scenario, interest rates are relatively high after accounting for expected inflation. In the second, inflation is expected to exceed the nominal rate.
This is why inflation expectations matter. Borrowing, saving, and investment decisions depend partly on what people expect prices to do over the period ahead, not simply on the inflation rate reported for the previous month or year.
For a forward-looking assessment of monetary policy, economists therefore generally compare nominal rates with expected inflation over a relevant horizon. Subtracting the latest reported inflation rate can provide a rough historical comparison, but it is not necessarily a reliable measure of the real rate influencing decisions today.
The Neutral Rate: What Makes Policy Restrictive?
A real interest rate tells us how high borrowing costs are after accounting for inflation. But whether that rate is restrictive depends on what level of interest rates the economy can sustain without being stimulated or restrained.
Economists call this benchmark the neutral real interest rate, often referred to as r-star (r*).
When the real policy rate is above the neutral rate, monetary policy is generally considered restrictive. When it is below the neutral rate, policy is generally accommodative.
Consider an economy where the neutral real rate is estimated at 1%.
- A real policy rate of 3% would be 2 percentage points above neutral, suggesting restrictive policy.
- A real policy rate of 0% would be 1 percentage point below neutral, suggesting accommodative policy.
What matters is not simply whether the real rate is positive or negative, but how it compares with the neutral rate.
The neutral rate is not fixed. It can change over time as factors such as productivity, demographics, saving behavior, and investment demand evolve. Nor can economists observe it directly. They must estimate it using economic data and models, which can produce different results.
Why the Degree of Restrictiveness Is Difficult to Measure
The comparison between real and neutral rates is useful, but the result depends on the estimates used.
Different measures of inflation expectations can give different answers. Household and business surveys capture what people expect, while market-based measures reflect inflation expectations alongside risk premiums and other influences. The choice of measure can therefore affect the estimated real policy rate.
Neutral-rate estimates can also disagree, even when economists examine the same economy. Models use different assumptions and methods, and their estimates may change as new data arrive.
Consider a real policy rate estimated at 2%, with neutral-rate estimates ranging from 1% to 2%. Policy would appear restrictive under the lower estimate but roughly neutral under the higher one. The same observed policy rate can therefore support different judgments about how much restraint the Fed is applying.
The time horizon matters as well. A policy rate may appear restrictive relative to an estimate of today's neutral rate, but businesses and households make decisions based partly on where they expect interest rates and inflation to go in the future.
Investors should also distinguish between the stance of policy and its eventual economic effects. A restrictive stance is intended to moderate demand and inflation, but it does not specify how quickly or strongly the economy will respond.
For investors, assessing whether Fed policy is tight or loose therefore involves weighing real interest rates against estimates of neutral, while recognizing that neither can be measured with complete certainty.
Photo: Federal Reserve Board / Federalreserve.