The Federal Reserve is not only going to cut interest rates at this week's meeting, but will also continue to cut rates in 2025.

According to a leading model calculated by the New York Fed, the current neutral interest rate is 0.8%. In contrast, using the Cleveland Fed's estimate of the expected one-year inflation rate, the inflation-adjusted federal funds rate is 1.9%.

The actual federal funds rate may not be the best rate to compare with the neutral rate, but other short-term rates tell a similar story. For example, the current one-year U.S. Treasury real yield is 0.7% higher than the neutral rate.

Moreover, over the past two decades, the one-year real interest rate in the United States has mostly been below the neutral interest rate—actually averaging 1.4% lower since 2003. Even if we ignore the pandemic period from 2020 to 2022, which is widely regarded as an exception, the one-year real interest rate has averaged 1.2% lower than the neutral rate. Hence, relative to the neutral rate, the current one-year real interest rate is almost 3% higher than the average level.

It should be noted that this conclusion comes with many conditions. The neutral interest rate cannot be directly observed, and different models provide different estimates. Additionally, expected inflation (used to calculate the current one-year real interest rate) cannot be directly observed and must be estimated. However, setting these aside, the current short-term real interest rate is clearly well above the average level.

Some researchers believe that the neutral interest rate may be lower than we think. Ricardo Caballero, an economics professor at MIT, is one of those researchers. He has recently put forward two main reasons why the neutral interest rate is likely to decline.

First is the 'unprecedented level of sovereign debt,' hence the need to encourage the private sector to be willing to lend money to the government. Although traditional views suggest that this means interest rates must rise, Caballero believes the opposite is true.

Caballero said: 'As the saying goes, “small loans are the borrower's problem; large loans are the lender's problem.” In this case, the issue lies with total demand. The primary deficits of highly indebted countries are unlikely to sustain total demand indefinitely. Therefore, lower interest rates are needed to encourage the private sector to fill the demand gap.'

Caballero's second reason for believing that the neutral interest rate will decline is that he believes the risk premium—the difference between expected returns on equities and fixed income—will have to rise from its current low level. To attract investors to take on the risk of equities, stocks must offer higher expected returns than U.S. Treasuries; however, the current earnings yield of the S&P 500 (the inverse of the price-to-earnings ratio) is below the yield on ten-year U.S. Treasuries—3.9% versus 4.4%. Given that the earnings yield on stocks is already far below historical averages, an increase in the risk premium is more likely to come from a decrease in interest rates.