The Neutral Rate: What It Is and Why It Matters Now

Key Takeaways

• The neutral rate—the interest rate at which monetary policy is neither accommodative nor restrictive—is a theoretical concept that cannot be directly observed, only estimated.
• The neutral rate is an important benchmark for the Fed and serves as a guidepost for its monetary policy.
• Estimates of the neutral rate change as economic conditions evolve, and they have declined dramatically in recent decades.

With another interest-rate-cutting cycle underway at the Federal Reserve, investors may be paying closer attention to the so-called “neutral rate” to help understand the central bank’s next moves. The neutral rate—sometimes called r* or “r star”—is a theoretical rate which neither stimulates nor restricts economic growth. The gap between the neutral rate and current policy rates rates helps investors see the bigger picture of the economy’s overall health and what the Fed is doing about it.

The neutral rate can’t be precisely measured, but the median estimate among Fed officials in September for long-run interest rates was 3%. Fed Chair Jerome Powell recently referred to the central bank’s current stance as “moderately restrictive,” meaning rates are somewhere slightly above the neutral rate.

The Fed held its target interest rate above 5% for more than a year beginning in 2023 to combat runaway inflation in the wake of the pandemic. The central bank adjusted rates lower once in September 2024 and again in September 2025. The Fed is expected to continue cutting rates in the months ahead to help prop up a cooling job market. The target federal-funds rate range is now 4.00%-4.25%.

Powell and other Fed officials have said they expect to move toward a more neutral stance in the months to come. In prepared remarks last month, Fed Vice Chair Michelle Bowman pointed to a “materially more fragile labor market” and inflation close to the Fed’s 2% target as reasons to move the policy rate down toward neutral and away from restrictive levels.

Why Is the Neutral Rate Important?

The neutral interest rate is like a “guiding light” for the Fed, says Lindsay Rosner, head of multi-sector fixed-income investing at Goldman Sachs Asset Management.

The Fed’s mandate is to promote a healthy economy by keeping employment at a maximum and inflation low and stable. It does this by raising or lowering the federal-funds rate, which is the interest rate banks use to lend money to each other overnight. The neutral rate is the theoretical middle ground policymakers are aiming for as they balance keeping inflation on target and employment at maximum levels.

When interest rates are above the neutral rate, monetary policy is considered to be tight, or restrictive. Higher rates mean higher borrowing costs, which helps slow the economy down and keeps inflation in check. If the federal-funds rate is below the neutral rate, policy is considered to be loose, or accommodative. Lower borrowing costs are intended to encourage spending and investment and help stimulate economic growth as well as the labor market.

In a 2018 essay, Federal Reserve Bank of Dallas President Robert Kaplan described how estimates of the neutral rate help policymakers understand the potential effects of their moves. “A good analogy is comparing this judgment to the assessment you typically make in approaching an intersection while driving your car,” he wrote. “Should you be pressing on the accelerator, easing off the accelerator, or pressing your foot on the brakes?”

How Is the Neutral Rate Estimated?

Crucially, the neutral rate can’t be measured directly. Instead, it’s a estimate that helps investors and economists understand whether and to what degree the Fed is taking a restrictive or accommodative stance. Rosner of Goldman Sachs describes it as an “academic notion of what keeps everything in balance.”

That means there isn’t a consensus of where the neutral rate lies. Fed Chair Powell emphasized this over the summer: “There are a range of views of what the neutral rate is at this moment for our economy … It’s not so mechanical. We understand that no one actually knows what the neutral rate is. We know it by its works.” He defines those “works” as the way the economy reacts to changes in the rate.

There are several academic models used to approximate the neutral rate. One popular method is the Holston-Laubach-Williams model, which incorporates data on GDP, inflation, and the target federal-funds rate. The model was updated in 2023 to account for volatility and economic shocks during the pandemic.

As of the second quarter of 2025, the Holston-Laubach-Williams model pointed to a real neutral rate of interest of 0.84%. Adding an inflation target of 2% yields a nominal neutral rate of a little less than 3%.

The Fed also publishes committee members’ long-run interest rate expectations—or neutral rate expectations—along with other economic projections each quarter. In September, the median estimate among the FOMC was for long-run interest rates of 3%.

Has the Neutral Rate Risen?

Just as economic conditions evolve over time, so too does the neutral rate. Estimates of the neutral rate have overall declined dramatically since the 1960s, according to the Holston-Laubach-Williams model, but they’ve ticked up slightly since their lows in the wake of the 2008 financial crisis.

Strategists say investors shouldn’t worry too much about the exact “neutral” level of interest rates. More important is their direction and magnitude relative to the neutral rate. Even though it can change, the neutral rate “gives you some insight on where the Fed’s monetary policy goal is,” says Goldman Sachs’ Rosner. “Are we far away from it? Are we close to it?” The answers help investors understand how much (and how quickly) central bankers could adjust their benchmark interest rate in the future.