Graph is via the folks at Trading Eocnomics.
Higher neutral-rate estimates are a structural argument for keeping long-dated yields elevated, which helps explain why bonds have sold off even with central banks already tightening. That matters for the curve and term premium more than for near-term policy moves. It also cuts against pricing that assumes a quick return to lower rates once inflation eases, since a higher resting point leaves less room for cuts. Equities have coped so far, but sustained pressure on long yields would test valuations, so traders will focus on whether yields rise on growth or on debt concerns.
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Economies are absorbing higher borrowing costs, and the neutral rate is the yardstick economists are using to argue over whether that reflects real strength or a heavier debt burden ahead.
Summary:
- Economists are raising estimates of the neutral rate of interest, the level at which borrowing costs neither restrict nor stimulate growth, according to the Wall Street Journal (gated).
- Goldman Sachs said an economy that sustains higher rates is a positive sign because it implies more underlying growth.
- The Fed’s median neutral estimate rose to 3.25% from 3.1%, the ECB’s chief economist put the top of the eurozone range at 2.5%, and Goldman estimates Japan’s has risen by about a quarter point.
- An economist at Oxford Economics linked the rise to the selloff in long-term government bonds and expects US neutral to climb another half point over five years.
- Drivers include AI-related productivity hopes and an investment surge, but also higher government debt, which economists see as the more worrying cause.
- Not all agree: a University College London professor warns of casualties among indebted governments, and ING’s Carsten Brzeski does not see a productivity case in Europe.
Some economists see a positive side to the global rise in borrowing costs: the economy looks strong enough to handle it. Sven Jari Stehn, chief European economist at Goldman Sachs, said it is a good sign that the economy can sustain higher interest rates, because it suggests there is more underlying growth. His argument rests on a concept called the neutral rate of interest, and economists are raising their estimates of it, according to the Wall Street Journal.
The timing matters. The Federal Reserve, Bank of Japan and European Central Bank are among the central banks that have raised rates to contain inflation driven by the war with Iran, and government bond yields have climbed to multidecade highs across the developed world. Investors expect further tightening and rates that stay higher for the foreseeable future. Even so, economies have shown resilience, and stocks have held up better than many feared, with corporate profits and the AI trade intact.
What the neutral rate is, and why nobody can see it
The neutral rate, often written as r*, is the level at which borrowing costs neither restrict nor stimulate economic growth. Think of it as the setting at which policy is neither pressing the brake nor the accelerator. It cannot be observed directly and has to be inferred from how the economy behaves. If growth and price pressures are rising, policy rates are probably below neutral and still supporting the economy. If growth and inflation are weakening, rates are probably above it.
Central bankers often treat neutral as a guide but say they do not target it. Fed Chairman Kevin Warsh said on Wednesday that it is useful academically but not relevant to his decision-making. The practical point is that neutral is a yardstick for judging how tight policy is, not a rate anyone sets.
The evidence that estimates are rising
- Federal Reserve: The median neutral-rate estimate in the Fed’s latest projections rose to 3.25% from 3.1%, an unexpectedly large increase according to Goldman.
- European Central Bank: The ECB’s chief economist estimated this summer that the eurozone’s neutral range has risen by a quarter of a percentage point, to 2.5% at the top end.
- Japan: Goldman estimated last month that Japan’s neutral rate has also risen by about a quarter point.
An economist at Oxford Economics believes the rise is just getting started. He projects US neutral rising by another half point over the next five years and the eurozone’s by about a quarter point.
Why it matters for central banks and bond markets
For the Fed, the question is whether policy is actually restrictive. Some policymakers described it as slightly restrictive earlier this year. On Wednesday, Warsh said he and his colleagues were hard-pressed to find evidence of that, with the labor market strengthening, and framed the latest increase as withdrawing some of the support policy had been providing.
On investingLive’s arithmetic, the Fed’s target range of 3.75% to 4.00% sits above the 3.25% median neutral estimate, which on paper would make policy restrictive. The gap explains why the estimate matters: neutral cannot be observed, and the median is a longer-run estimate rather than a real-time reading of where neutral sits today. The higher the estimate goes, the smaller the gap becomes.
The same logic applies in Europe. If markets are right that the next ECB move is a quarter-point rise in the deposit rate to 2.75%, that would put the rate above the top of the neutral range the ECB’s chief economist described. That is a point to watch as policymakers debate whether to keep tightening or pause.
Bond markets are already reacting. The Oxford Economics economist said rising neutral estimates have helped fuel the selloff in long-term government bonds, because yields reflect where investors expect central bank rates to be in the future, alongside factors such as debt sustainability. Some on Wall Street have warned that high rates could pull money out of stocks and into higher-yielding bonds, but the Journal reports that this has not materialised so far.
Why neutral estimates are rising: the growth story and the debt story
The optimistic explanation is growth. The Oxford Economics economist said expectations of higher AI-driven productivity are partly responsible in both the US and Europe, although he expects Europe to see the full effect later because of slower adoption. More productivity growth brings more tax revenue, he said, which makes higher rates more manageable. Warsh said last month that the global savings glut, which many economists blame for pushing rates lower, is now over and that this is a moment of global investment surge.
The historical backdrop helps explain the shift. Academic research shows neutral rates have been falling since the 1980s, which many economists partly attribute to ageing populations saving more for retirement and a weaker appetite for productive investment. Former Fed Chair Ben Bernanke later argued that countries such as China pushed rates down further by investing large trade surpluses in safe assets such as US Treasurys, which he called a global saving glut.
The worrying explanation is debt. Rising government debt means borrowers have to pay higher interest rates to persuade investors to buy more of it, so part of the rise in neutral reflects the cost of funding that debt rather than economic strength. Central banks, for their part, are likely to welcome a higher neutral rate. It gives them more room to raise rates against inflation and more room to cut in a downturn, after a decade in which they worried that low rates would leave them short of tools in a crisis.
Where economists disagree
Lukasz Rachel, an economics professor at University College London, described the low-rate era as a warning that the future looked bleak, so a higher neutral rate is in that sense good news. He still worries about casualties, especially governments that will struggle to cover rising interest bills, and said moving from secular stagnation to high and rising yields within a few years will inevitably catch some off guard.
Others question whether growth prospects have brightened at all, particularly outside the US. Carsten Brzeski, global head of macro research at ING, said a higher neutral rate makes more sense in the US than in Europe, where he does not see the productivity story or any increase in potential growth.
What to watch
The reading of strength depends on the data continuing to hold up. Strong labor market and growth readings, along with evidence that AI investment is lifting productivity, would support the higher-neutral case. Cooling growth and inflation while rates stay this high would point the other way, because that is how economists infer that policy has moved above neutral. Long-dated yields matter too, since a rise driven by debt concerns rather than growth tells a less comfortable story. The next Fed projections and the ECB staff projections will show whether estimates keep climbing.
The practical takeaway is that when someone calls policy restrictive, the useful follow-up is: relative to which estimate of neutral?
This article was written by Eamonn Sheridan at investinglive.com.