Like many other economic concepts, the neutral rate remains rooted in theory. Of course, the economy rarely chugs along in a textbook fashion. 

Here is how to think about it in terms of a math equation: 

Inflation target + real trend rate of economic growth = neutral rate

The Fed’s inflation target is at 2%, so that’s easy enough to plug in. But it gets tricky when trying to determine the economy’s long-term sustainable real growth rate, which is an estimated figure. 

Some models have tried to predict where the neutral rate is at. 

These two are some of the most famous ones: The Laubach-Williams and Holston-Laubach-Williams models provide estimates of the natural rate of interest, or r-star, and related variables, according to the Federal Reserve Bank of New York. To them, it is the rate expected to prevail when an economy is at full strength and inflation is stable.

The Laubach-Williams from 2003 model uses data on real GDP, inflation, and the federal funds rate to extract trends in U.S. economic growth, and other factors influencing the natural rate of interest. Holston, Laubach, and Williams from 2023 extends the model to include other economics, as well—and it also includes the supply shock from the Covid-19 pandemic.

Among the factors that affect the neutral rate include price of capital, demographics, risk aversion, the global savings glut, and inequality. 

Over the past few decades, the neutral rate has tumbled. That’s mostly because of demographics. As fewer employees enter the workforce and the population growth slows, it translates to increased savings and reduced demand for capital, which lowers the rate needed to maintain economic stability.

Since 1961, the estimated neutral rate has declined by about 4.7 percentage points, according to one model. And after the Fed started raising rates in 2022 to tame multidecade highs in inflation, the neutral rate has declined even more. 

Members of the Fed currently project the neutral rate at around 2.5% to 3%, the latest dot plot release shows. 

Since the neutral rate is a moving target, one doesn’t know if it has been reached until much later. Like many other Fed policy tools, this one too looks backward and we all know the problems with that. 

Regardless, the Fed is always aiming for the neutral rate to keep the economy growing but not too fast, as it’s all about striking a balance. 

We wonder if during difficult days the Fed too has to remind itself that the Force is always going to be with us.