RETHINKING THE NEUTRAL RATE

Understanding the “Neutral” Interest Rate and Its Impact on Mortgage Rates

Why the Fed Thinks The Neutral Rate Is Higher Than Most Think It Is

Federal Reserve Chair Jerome Powell just told Congress that he believes the “neutral” interest rate, which is the rate that doesn’t stimulate or slow the economy, has risen significantly from its pre-pandemic levels. His colleagues at the Federal Open Market Committee (FOMC) are backing Powell’s take.

Why is the shift important? Because it suggests that mortgage rates may have entered a “new normal” range, meaning they might stay higher for longer than many expected.

You Say “Nominal,” I Say “Real,” Let’s Call The Whole Thing “Neutral”

When people refer to the “neutral” interest rate, a lot of the time they’re thinking about “nominal” rates (the stated rate before inflation). In economic theory, though, true neutral rate is a “real” rate, meaning it’s adjusted for inflation.

Powell said in a recent press conference that the federal funds rate is currently above most FOMC participants’ estimates of the long-run (not adjusted for inflation) neutral rate. But here’s a problem: these estimates assume long-term inflation at 2%, and that is not reality today. With inflation expectations currently around 2.6%, the real (adjusted for inflation) rate sits at approximately 1.7%.

Why This Matters for Mortgage Rates

Since the market views the neutral rate as higher than FOMC estimates, the current monetary policy might not be as restrictive as some believe. This suggests that the Federal Reserve may not cut rates as aggressively as some expect, meaning mortgage rates could remain elevated for longer.

The Bottom Line

The Fed and the market disagree on the long-term neutral interest rate, with markets expecting a higher rate than most FOMC participants.

Mortgage rates may have entered a “new normal” range and are unlikely to return to pre-pandemic lows anytime soon.

For homebuyers and homeowners, this means that waiting for significantly lower mortgage rates might not be a realistic strategy in the near future. Instead, borrowers should prepare for an environment where rates remain elevated compared to the past decade.

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Disclaimer: This post is offered for informational purposes only and should not be construed as financial or legal advice. Home buyers and sellers must always perform their won due diligence and seek counsel from licensed professionals such as CPAs and attorneys when making choices relating to a real estate transaction. We do not endorse individual service providers and citations should not be considered endorsements.