Increasingly, we are hearing central bankers yearn for a ‘neutral ‘policy rate as they pursue a path of rate hikes. Earlier this month, Federal Reserve Chairman Powell said his central bank is a ‘long way’ from reaching a neutral Fed funds rate. Today, the Governing Council of the Bank of Canada ‘agrees that the policy interest rate will need to rise to a neutral stance ‘. Just what is meant by the term a ‘neutral’ rate and what are the underlying economic conditions that can support a neutral rate have been debated for years.

The question of the neutral rate is critical for the central bank policymaking. By definition, “the neutral rate of interest is the real policy rate that prevails when an economy’s output is at its potential level and inflation is at the central bank’s target”[1], i.e. the economy’s sweet spot. The neutral rate has been falling over the past three decades, along with nominal rates, as world inflation rates steadily declined. Although economists can only build theoretical models to determine the rate, the rate, itself, is not observable.

The neutral rate can be considered as a benchmark to gauge the degree of monetary stimulus in place. If the bank rate is below the neutral rate, then monetary policy is considered to be simulative; above the neutral rate, monetary policy is restrictive.

The Bank of Canada has set the neutral rate between 2.5% and 3.5%. For the purposes of building their projections, the Bank uses 3% as the neutral rate. The key question is: what could derail the Bank in moving towards the neutral rate?

The Bank identifies two major risks that could affect the projected path for inflation and hence its ability to reach a neutral rate. First, China-U.S. trade could escalate much further with severe consequences for global trade and growth. Commodity prices could collapse and Canadian exports would suffer from a significant weakening of foreign demand. Canadian business investment could slump badly as business confidence plunges. High tariff walls would be inflationary and this would likely increase global industrial costs and lower production. Simply put, U.S. trade policy remains the wild card in the global economy.

Second, the Bank re-iterates that it must consider how the domestic economy will adjust to successive rate hikes, given the relatively high level of household debt. This adjustment will be most keenly felt in the housing market, especially in the greater Vancouver and Toronto areas. The Bank has to walk the fine line of raising rates without precipitating a deep slump in home prices, otherwise, consumption, housing demand, and construction activity could suffer a severe downturn.

A final note. Although the Bank withdrew the term ‘gradual’ when speaking of the path of rate increases, bank officials were quick to warn observers not to assume a fast pace towards the neutral rate. Policymaking will continue to be data-dependent, especially given these risks.

[1] “An Up Date On the Neutral Rate of Interest”, Bank of Canada Review , Autumn 2017