Neutral rate estimates climb at Fed, ECB, Japan; impact on bonds and borrowers

Rising estimates of the neutral rate provide a structural case for elevated long-term bond yields, explaining why fixed-income markets have declined despite ongoing central bank tightening. This development has greater implications for the yield curve and term premium than for short-term policy decisions. It also challenges market pricing that anticipates a rapid return to lower rates after inflation subsides, because a higher neutral level reduces the scope for rate cuts. Equity markets have absorbed the pressure so far, but prolonged upward pressure on long yields would challenge valuations. Investors are therefore watching whether yield increases stem from stronger growth or from rising debt worries.

Economies are currently absorbing increased borrowing expenses, and economists are employing the neutral rate as a benchmark to debate whether this indicates genuine economic vigor or a looming heavier debt load.

• According to the Wall Street Journal (gated), economists are boosting their estimates of the neutral interest rate—the level where borrowing costs neither spur nor restrain growth.
• Goldman Sachs stated that an economy capable of sustaining higher rates is a positive indicator, as it suggests greater underlying growth.
• The Fed's median neutral estimate increased to 3.25% from 3.1%, the ECB's chief economist placed the eurozone's upper bound at 2.5%, and Goldman estimated Japan's neutral rate rose by roughly a quarter point.
• An Oxford Economics economist attributed the rise to the sell-off in long-term government bonds and predicted US neutral will climb another half point over five years.
• Driving factors include AI-related productivity optimism and an investment boom, but also elevated government debt—which economists view as the more concerning driver.
• Not everyone concurs: a University College London professor warned of casualties among heavily indebted governments, and ING's Carsten Brzeski sees no productivity case in Europe.

A number of economists perceive a silver lining in the global increase in borrowing costs: the economy appears robust enough to manage it. Goldman Sachs' chief European economist Sven Jari Stehn said it is a good sign that the economy can sustain higher interest rates, because it suggests there is more underlying growth. His reasoning is based on the neutral rate concept, and economists are increasing their estimates of it, the Wall Street Journal reports.

The timing is significant. The Fed, BOJ, and ECB are among central banks that have hiked rates to curb inflation stemming from the Iran conflict, and sovereign bond yields have reached multi-decade peaks throughout developed economies. Market participants anticipate additional tightening and rates remaining elevated for the near term. Nonetheless, economies have demonstrated resilience, and equities have performed better than many anticipated, supported by corporate earnings and the AI theme.

What the neutral rate is and why it remains invisible

The neutral rate, commonly denoted as r*, is the interest level where policy neither stimulates nor restrains economic growth. It can be thought of as the setting where monetary policy is neutral. This rate cannot be directly observed and must be inferred from economic behavior. When growth and price pressures are increasing, policy rates are likely below neutral, still supporting the economy. When growth and inflation are weakening, rates are likely above neutral.

Central bankers typically regard neutral as a reference point but emphasize they do not aim for it. Fed Chair Kevin Warsh stated on Wednesday that the concept is academically useful but not pertinent to his policy choices. The essential takeaway is that neutral serves as a gauge for assessing policy restrictiveness, not a specific rate that authorities target.

Evidence that neutral rate estimates are climbing

• Federal Reserve: The median neutral-rate estimate in the Fed's latest projections increased to 3.25% from 3.1%, a rise that Goldman described as unexpectedly large.
• 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, with the top end at 2.5%.
• Japan: Goldman estimated last month that Japan's neutral rate has also risen by roughly a quarter point.

An Oxford Economics economist believes the increase is only beginning. He forecasts US neutral rising by an additional half point over the next five years and the eurozone's by roughly a quarter point.

Relevance for central banks and bond markets

For the Fed, the key question is whether policy is genuinely restrictive. Earlier this year, some policymakers characterized it as mildly restrictive. However, on Wednesday, Warsh remarked that he and his peers found little evidence of restrictiveness amid a strengthening job market, and he characterized the latest hike as pulling back some of the support previously provided.

According to investingLive's calculation, the Fed's current target range of 3.75% to 4.00% exceeds the median neutral estimate of 3.25%, theoretically implying restrictive policy. This discrepancy illustrates why the neutral estimate matters: neutral is unobservable, and the median is a long-run projection rather than a current real-time reading. As the neutral estimate rises, the gap narrows.

The same reasoning holds for Europe. If markets correctly anticipate that the ECB's next step will be a quarter-point increase in the deposit rate to 2.75%, that would place the rate above the upper end of the neutral range cited by the ECB's chief economist. This will be a key focus as policymakers deliberate on whether to continue tightening or to pause.

Bond markets have already responded. The Oxford Economics economist noted that rising neutral estimates have contributed to the sell-off in long-term government bonds, as yields incorporate expectations of future central bank rates along with considerations like debt sustainability. While some Wall Street voices have cautioned that elevated rates might divert funds from equities to higher-yielding bonds, the Journal reports that this shift has not occurred yet.

Reasons for rising neutral estimates: growth narrative and debt narrative

The optimistic view centers on growth. The Oxford Economics economist said expectations of higher productivity driven by artificial intelligence are partly behind the rise in both the US and Europe, though he expects Europe to experience the full impact later due to slower adoption. He added that increased productivity growth generates more tax revenue, making higher rates more manageable. Last month, Warsh said the global savings glut—which many economists blame for suppressing rates—has ended, and that the world is now witnessing a surge in investment.

The historical context sheds light on the change. Academic studies indicate that neutral rates have been declining since the 1980s, a trend many economists partially ascribe to aging populations saving more for retirement and a reduced appetite for productive capital investment. Former Fed Chair Ben Bernanke later argued that nations like China drove rates even lower by deploying large trade surpluses into safe assets like US Treasuries, a phenomenon he termed a global saving glut.

The more concerning explanation is debt. Increasing government debt forces borrowers to offer higher interest rates to attract investors, meaning part of the neutral rate rise reflects the cost of financing that debt rather than economic vigor. Central banks, however, are likely to view a higher neutral rate favorably. It provides them greater scope to hike rates to combat inflation and more capacity to cut during a downturn, following a decade when they feared low rates would leave them deficient in crisis-fighting tools.

Disagreement among economists

University College London economics professor Lukasz Rachel characterized the low-rate era as a warning of a bleak future, so a higher neutral rate is good news in that regard. Nonetheless, he remains concerned about casualties, particularly governments that will find it hard to meet rising interest payments, and he stated that the transition from secular stagnation to high and climbing yields within a few years will inevitably take some by surprise.

Other economists doubt that growth prospects have genuinely improved, especially beyond the US. ING's global head of macro research Carsten Brzeski said a higher neutral rate is more plausible in the US than in Europe, where he sees no productivity narrative or any uptick in potential growth.

Key points to monitor

The assessment of economic strength hinges on data maintaining its resilience. Robust labor market and growth figures, combined with indications that AI investment is boosting productivity, would reinforce the higher-neutral thesis. If growth and inflation cool while rates remain elevated, that would suggest policy has moved above neutral, pointing in the opposite direction. Long-term yields also matter, as an increase driven by debt worries rather than growth paints a less reassuring picture. The upcoming Fed and ECB staff projections will indicate whether estimates continue to rise.

The key practical lesson is that when policymakers describe policy as restrictive, the relevant follow-up question is: compared to which neutral rate estimate?