"The neutral rate is the theoretical federal funds rate at which the stance of Federal Reserve monetary policy is neither accommodative nor restrictive. It is the short-term real interest rate consistent with the economy maintaining full employment with associated price stability. You won’t find the neutral rate quoted on your computer screen or in the financial section of the newspaper. The neutral rate is an “inferred” rate—that is, it is estimated based on various analyses and observations."So what are the Federal Reserve policymakers current inferring? At each meeting, the participants provide their own estimates of the neutral rate. Kaplan writes:
"Each of us around the FOMC table submits quarterly, as part of the Summary of Economic Projections (sometimes referred to as the SEP or the “dot plot”), our best judgments regarding the appropriate path for the federal funds rate and the “longer-run” federal funds rate. My longer-run rate submission is my best estimate of the longer-run neutral rate for the U.S. economy. In the September SEP, the range of submissions by FOMC participants for the longer-run rate was 2.5 to 3.5 percent, and the median estimate was 3.0 percent. My own estimate of the longer-run neutral rate is modestly below the median of the estimates made by my colleagues. My suggested rate path for 2019 is also modestly below the 3 to 3.25 percent median of the ranges suggested by my fellow FOMC participants."So based on what Fed policy-makers are saying, that seems like what is likely to happen (of course, barring substantial shifts in the economy that would lead to a reevaluation of plans). But is it what should happen? Kaplan makes the case for his own view, which in part involves looking at some prominent economic models that try to estimate the "neutral" interest rate. Thus, he writes:
"These models differ in terms of their structural assumptions and the data they use to produce estimates of the neutral rate. For example, Laubach–Williams uses data on real GDP, core PCE inflation, oil prices, import prices and the federal funds rate as inputs for their model. This model attempts to estimate an output gap to assess the neutral rate of interest. The Koenig model uses data on long-term bond yields, survey measures of long-term GDP growth and long-term inflation as inputs for its estimates of long-run r*. Giannoni’s model uses a broad set of key macroeconomic and financial data series to generate estimates of the neutral rate at different time horizons."All of these models suggest that the neutral interest rate is lower now than, say, 15-20 years ago, when it was more in the range of 5%. The estimates are surrounded by a reasonable degree of uncertainty. But they generally support Kaplan's argument that the Fed should continue along its current path of interest rate increases.