Federal Reserve officials have started shifting monetary policy to neutral, a process rife with economic risks, and one that could end sooner than anticipated.

The Fed on Sept. 18 approved a 50-basis-point cut to the benchmark federal funds rate and boosted officials' median projections for the longer-run federal funds rate to 2.9%, up from 2.5% at the end of 2023 and the highest projection in six years.

The fresh projections show that the Fed's expected neutral rate of interest — an equilibrium where monetary policy neither contracts nor expands the economy — is climbing, reflecting better-than-expected economic growth and indicating fewer rate cuts going forward. Uncertainty over just where that neutral rate should be has heightened the risk of the Fed adjusting rates improperly, potentially reversing progress in bringing inflation down to the central bank's 2% target or driving up joblessness after months of historically low unemployment.

"The economy is rarely in equilibrium, but it should be a target until data emerges that demands a response," said Michael O'Rourke, chief market strategist at JonesTrading. "There is an important risk involved though. If the Federal Open Market Committee is incorrect in its forecast of the neutral rate, it could be moving policy to an inappropriate target and creating a policy error."

'We're going to find out'

The neutral rate of interest — also known as the long-run equilibrium interest rate, the natural rate or r-star — may be getting more intense scrutiny from the market after years of near-zero rates, which Fed officials claim are unlikely to return.

"It seems that's so far away now, my own sense is that we're not going back to that," Fed Chairman Jerome Powell said in announcing the Fed's Sept. 18 rate decision. "But honestly, we're going to find out."

Powell said the neutral rate is "probably significantly higher" than it was just a couple of years ago, although it remains unknown just how much higher.

Raphael Bostic, president of the Federal Reserve Bank of Atlanta; Mary Daly, president of the Federal Reserve Bank of San Francisco; and Patrick Harker, president of the Federal Reserve Bank of Philadelphia, have all said they believe the neutral rate is at 3% or higher.

"The rising longer-run [projections] indicate policymakers are very uncertain about whether the underlying structure of the economy will ever go back to the pre-COVID state of things," said Derek Tang, an economist with LH Meyer/Monetary Policy Analytics. "The recently tight policy, when the funds rate was held at 5.5%, did not suppress demand as much as they expected, which is why they suspect maybe policy was not very restrictive and neutral could have risen higher."

Moving up

Over a relatively long time frame, the neutral rate of interest is determined almost entirely by potential economic growth, said Satyam Panday, chief US economist at S&P Global Ratings.

Stronger economic growth implies a higher return on capital and leads to higher investment demand as an increasingly positive outlook for growth boosts future earnings and leads forward-looking US households to consume more and save less. This all leads to a rise in the neutral rate of interest, Panday said.

"The rise in [the neutral rate] penciled in by the Fed tells us that the Fed officials believe the economy's potential growth is now stronger than what was deemed during 2018 through 2019," said Panday. "It really comes down to productivity growth story. If we continue to see productivity growth surprise to the upside, it wouldn't be surprising to see real neutral rate continue to move up incrementally."

The upward revision in the neutral rate was likely driven by increases in productivity led by advancements in AI and the recent surge in immigration, which helped balance one of the most supply-constrained labor markets in decades, said Oren Klachkin, a financial market economist with Nationwide.

Still, the revision was relatively modest and Klachkin believes the Fed still has "quite a bit of room to cut."

"It's an important thought exercise, but calibrating policy based only on an estimate of neutral isn't prudent," Klachkin said. "It serves as a rough guide, at best. Fed officials shouldn't calibrate policy based on it alone because there's a lot of uncertainty on where it sits, both in the short- and long-term."

The neutral rate could be a crucial device for communicating future rate moves rather than a roadmap for the path of policy, said Tang with LH Meyer/Monetary Policy Analytics.

"They will keep mentioning a higher neutral to make sure financial conditions like the yield curve do not ease too much, but they will not necessarily hold themselves to setting policy around neutral in a mechanical way," Tang said.