[News Terms] Ongoing Controversy Over 'Neutral Interest Rate' Even After Jackson Hole

After the Jackson Hole meeting held in Wyoming, USA from the 24th to the 26th (local time), the issue that the Bank of Korea is closely monitoring is the neutral interest rate in the United States.

The neutral interest rate refers to the rate at which the economy neither overheats (inflation) nor contracts (deflation) but achieves its potential growth rate. It is a theoretical interest rate level naturally formed according to market demand and supply. Simply put, it is an optimized interest rate suitable for a country's economic situation, first proposed by Swedish economist Knut Wicksell in the 1890s when he distinguished between market interest rates and natural interest rates.

The neutral interest rate did not receive much attention afterward, but it began to be highlighted again in the 1990s when the main tool of monetary policy shifted from money supply to interest rates and central banks started adopting inflation targeting. It has been frequently mentioned as a benchmark for monetary policy, especially after the global financial crisis. A representative example is former U.S. Federal Reserve (Fed) Chairman Ben Bernanke's statement at the American Economic Association (AEA) meeting held in San Diego, California, in January 2020, where he said, "If the neutral interest rate is around 2-3% per year, quantitative easing and forward guidance can produce policy effects equivalent to an additional 3 percentage point cut in interest rates." Former Fed Chair Janet Yellen also explained the justification for quantitative easing and zero interest rate policies by citing the neutral interest rate, saying, "Since the neutral interest rate is at a negative level, monetary policy can be further eased." Ahead of this Jackson Hole meeting, the market was keenly attentive to Fed Chair Jerome Powell's remarks on the neutral interest rate because they could provide hints about the future direction of monetary policy.

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If the policy interest rate is lower than the neutral interest rate, economic agents' investments become active, leading to economic expansion and increased employment, but this can cause inflation as prices rise. Conversely, if the policy interest rate is higher than the neutral interest rate, the economy contracts, employment decreases, and prices fall. Therefore, if economic conditions do not meet the economy's fundamental strength, central banks can stimulate the economy through an accommodative monetary policy by keeping the policy interest rate lower than the neutral interest rate. Similarly, to cool down an overheated economy, they can implement a tightening monetary policy by raising the policy interest rate above the neutral interest rate.

In this way, the neutral interest rate is important because it allows central banks to understand how accommodative or restrictive the current policy interest rate is when they want to change it. The Fed announces the median estimate of the neutral interest rate quarterly, and the median announced in June was 0.5%. However, among the 17 members, 7 expected it to exceed 0.5%, which was 5 more than a year ago, attracting market attention. Amid this, opinions in the economics community about the direction of the real neutral interest rate are sharply divided, further intensifying the debate on the neutral interest rate.

Meanwhile, the Bank of Korea does not officially announce the neutral interest rate. The nominal neutral interest rate in Korea estimated by the financial investment industry is roughly in the 2% range. However, since the neutral interest rate cannot be directly observed and must be estimated from economic conditions, and because it changes reflecting shifts in the economy's fundamental strength, estimates vary depending on the method, with some mentioning figures in the 1% range and others in the 4% range.

This content was produced with the assistance of AI translation services.