Federal Reserve officials emphasize that their decisions are closely tied to economic data and indicators of the economy's health and potential trajectory. A key guiding principle for the Fed is the concept of the 'neutral rate of interest,' which Chair Jerome Powell describes as theoretical and not directly observable.
The neutral rate of interest is the level of interest rates that neither stimulates nor dampens the economy. The Fed primarily uses its key interest rate to influence borrowing costs throughout the economy. This tool can either boost demand when rates are low or cool it down when rates are high, depending on whether the Fed is addressing high inflation or high unemployment.
Economists consider the neutral rate of interest as theoretical due to its dependence on numerous factors, such as population growth, productivity, savings behavior, structural changes in the economy, and the impact of borrowing costs.
With inflation significantly lower than its peak in 2022 and close to the Fed's 2% target, the Fed has shifted its focus towards the U.S. job market, which has shown signs of weakening in recent years. While the job market remains strong, Powell indicated in September that the Fed is committed to preserving its strength and preventing any deterioration.
Fed officials believe that current borrowing costs are still relatively high, posing a risk to the labor market. The pace at which the Fed aims to return interest rates to the neutral rate of interest is now under consideration, with inflation playing a crucial role in this decision-making process. Some officials have expressed a lack of urgency in reducing rates.
Atlanta Fed President Raphael Bostic stated last month that he is not rushing to reach the neutral rate of interest. He emphasized the importance of bringing inflation back to the 2% target and avoiding a scenario where inflation stagnates due to insufficient restrictions. Bostic emphasized the need for patience in this regard.
