The Federal Reserve announced a rate cut of 25 basis points this morning as expected, but hinted that it will slow the pace of rate cuts next year, cutting only 50 basis points instead of the 100 basis points previously anticipated in September. Fed Chairman Powell also stated that we are now close to the neutral interest rate. As the pace of rate cuts was not as fast as the market expected, major U.S. stock indexes closed sharply lower, and the cryptocurrency market also experienced a plunge.

In this regard, Nick Timiraos, a reporter for the Wall Street Journal known as the 'Fed's mouthpiece,' wrote that how far the U.S. is from the neutral interest rate will be the core issue determining the future direction of Fed policy. The higher neutral rate forecasts in the post-pandemic era also indicate the end of the ultra-low interest rate era.

Will we not return to ultra-low rates?

The neutral interest rate is the level at which the economy operates at full employment and stable inflation. This level cannot be directly observed but must be inferred by economists and policymakers based on economic behavior. If borrowing and consumption are strong, price pressures rise, and the current interest rate may be below the neutral rate. Conversely, if borrowing and consumption are weak and inflation declines, the interest rate may be above the neutral rate.

The article pointed out that earlier this year, discussions about the neutral interest rate were not important because rates were at levels that nearly all Fed officials considered restrictive. However, as the Fed has cut rates by 1%, and the economy seems to be in good shape, the issue of the neutral interest rate has become the focus. If it is believed that the neutral interest rate has risen, Fed officials may become more cautious when considering further rate cuts.

Powell mentioned at the post-meeting press conference on Wednesday:

We cannot accurately know where the neutral interest rate is, but we can be sure that we are closer to it now than before. From here, we have entered a new phase and will remain cautious about further rate cuts.

Nick Timiraos stated that after the 2008 financial crisis, economists and Fed policymakers gradually lowered their estimates of the neutral interest rate. The ultra-low rates and massive monetary stimulus have failed to bring significant economic growth. Some economists believe that due to labor shrinkage from an aging population and long-term insufficient demand for new investment, low interest rates will become the norm.

However, some economists believe that the massive fiscal stimulus during the pandemic has caused the economy to enter a new equilibrium state, leading to an increase in the neutral interest rate over the past few years.

The Fed forecasts long-term interest rates every quarter, which is effectively an estimate of the neutral interest rate. The median forecast dropped from 4.25% in 2012 to 2.5% in 2019 and has remained at that level until 2023. However, the neutral interest rate forecast has risen in all four quarters of this year, with the latest forecast on Wednesday being 3%. Among the 19 officials, 8 have estimates above 3%.

Trump's policies influence rate cut decisions

The article mentioned that the economy remains strong despite rising interest rates, which may only reflect some temporary factors, such as increased immigration or businesses and households locking in low-rate loans during the pandemic. However, if the economy continues to grow over time, it could indicate that the neutral interest rate has entered a new normal at a higher level. If officials conclude that the neutral interest rate has risen, the Fed may pause rate cuts for a considerable time.

As officials try to determine the level of the neutral interest rate, incoming President Trump has promised to reform trade and immigration policies. New shocks could complicate the determination of a new economic normal, and with inflation still above target, this may further strengthen the Fed's cautious attitude towards rate cuts.