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After a steep rise in interest rates around the world, it’s natural to question at what point central banks will stop. This is where bankers start using a technical term: “neutral level”. The thing is, what exactly constitutes a “neutral level” is a little more complicated and somewhat deliberately vague. And that can be a bit of a challenge for traders trying to position themselves.

The big deal with interest rates reaching a neutral level is that the entire market dynamics would shift. Right now, particularly currencies, are being driven by expectations around interest rates and inflation. That is particularly true of the EURUSD and GBPUSD, as the “real spread” (the differential in interest rates considering inflation) is one of the main explanations for dollar strength.
 

Finding neutral

The basic concept of a “neutral level” for interest rates is fairly straightforward. It’s when we try to interpret that in the context of a policy that things get a bit complicated. So, the general notion is that there is a certain interest rate where the influence from the central bank is “balanced”. That is, interest rates aren’t too low (which leads to higher inflation), nor too high (which hurts the economy).

The issue is that “too low” and “too high” are somewhat subjective and is changes all the time. So, while central bankers like to talk about achieving a “neutral level”, they are typically very reluctant to say what that level is. 2.0%? 3.0%? 15%? “Well, we’ll have to look at the data.”
 

Applying it to trading

The problem for traders is that the value of currencies, especially now, is dependent on how much more rates are going to be increased. Take the Euro, for example. The current interest rate is 0%. If the ECB thinks that a “neutral rate” is around 2.0%, that means they will hike rates four times (or less, if by larger amounts) in the very near future. But if they think the neutral rate is 3.0%, then they will have to raise rates six times. And will be more likely to raise by 50 or even 75bps at a time. Obviously, that radically impacts the behavior of Euro pairs.

So, trying to figure out where central bankers think the neutral rate helps with figuring out how markets will behave, and in turn how to position our trades. But typically, central bankers give more vague guidelines, like “still far from neutral”, “getting close to neutral”, or “likely to reach neutral in the short term.”
 

Putting some empiricism behind it

Central bankers are reluctant to give out a precise number because that becomes a more concrete prediction. It’s easier to keep raising rates, for example, if you said, “we’re near neutral” at 1.50%; than saying, “neutral is at 2.0%” and then needing to raise rates to 2.25 or 2.50%.

The bottom line, however, is that the definition still determines the rate. Central bankers might have opinions on where the neutral rate should be, but all those opinions will converge as the data shows that inflation is starting to line up with the target and the economy is still growing. Or the opinions will start to diverge if the economy suffers, or inflation keeps increasing.

While it’s worth speculating, unless inflation has a couple of months of concrete reduction, talking about the “neutral” rate is pretty much an academic exercise. But it’s likely something central bankers will increasingly talk about as the time for slowing down or outright stopping rate hikes comes around.

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