The Fed nudges its long-run rate higher

The Federal Open Market Committee left its policy rate at 5.25–5.50 per cent in March. Analysts paid more attention to a small change in the Summary of Economic Projections. The median estimate for the longer-run federal funds rate, which the committee uses as a proxy for the nominal neutral rate, rose from 2.5 to 2.6 per cent.

What else the projections said

The headline numbers were more dovish than many traders feared. The median official still expects three quarter-point cuts this year, unchanged from December, even though inflation in January and February ran hotter than hoped. Beyond this year the picture was firmer. The median projection for the policy rate by the end of 2025 rose to 3.9 per cent, and by the end of 2026 to 3.1 per cent, implying fewer cuts in total. Officials also raised their forecast for growth this year and nudged up their forecast for core inflation.

The combination explains the market's reaction. Stocks rallied and short-dated Treasury yields fell, because the near-term path of cuts survived. The longer-dated projections got less attention on the day, but they carry the bigger message about where rates settle once the cutting is over.

Ten basis points that matter

A ten-basis-point shift looks trivial. For a committee as cautious as the FOMC, it amounts to a real change of mind. Several members put their own dots above three per cent, accepting that a stronger, more productive economy and heavy government borrowing are lifting the equilibrium rate of interest. The policy rate is probably not going back to its post-crisis lows.

How the long-run rate is read

The longer-run projection is each official's view of where the policy rate should settle once the economy is at full employment, inflation is at 2 per cent and no shocks are pushing it either way. Subtract the 2 per cent inflation target and what remains is an estimate of the real neutral rate, the rate that neither stimulates nor restrains growth. At 2.5 per cent the committee was implying a real neutral rate of 0.5 per cent, among the lowest estimates in the Fed's history. The move to 2.6 per cent raises it only slightly, but it breaks a median that had been stuck for about five years.

The estimate matters for markets because it anchors expectations of where short-term rates will average over the long run. A ten-year Treasury yield is roughly the expected average of short-term rates over a decade plus a term premium. If investors come to believe that the neutral rate is higher, the whole curve shifts up, even when current policy is unchanged. That feeds through to mortgage rates, corporate borrowing costs and the valuation of long-dated assets.

The history of the estimate shows how slowly it moves. When officials began publishing a longer-run projection in 2012, the median stood above 4 per cent. It was marked down in small steps over the following seven years, as growth and inflation kept undershooting forecasts, and reached 2.5 per cent in 2019. Those cuts helped markets come to treat near-zero policy rates as the normal state of affairs for most of the 2010s.

The forces behind the drift

Three developments have pushed officials to rethink. The economy absorbed a rise of more than five percentage points in the policy rate over 2022 and 2023 without a recession, which is hard to square with a very low neutral rate. Federal deficits remain large even with unemployment below 4 per cent, absorbing saving that would otherwise hold rates down. Investment demand is climbing, driven by subsidies for clean energy and semiconductor plants and by the data centres needed for artificial intelligence. Productivity growth picked up last year, which, if sustained, would raise the return on capital.

The case for the old view

The counterargument is that the forces that pushed the neutral rate down have not disappeared. Populations in rich countries are still ageing, global saving remains high, and demand for safe assets jumps in any crisis. Model-based estimates of the neutral rate, such as those published by the New York Fed, have barely moved. Some officials who raised their dots may simply be reacting to recent strong data rather than making a durable judgement. On this view, a ten-basis-point shift in a median is noise.

That may prove right, and one set of projections does not make a trend. But the direction of the revision is consistent with what markets have been signalling through higher real yields, and a committee that took years to lower its estimate is unlikely to raise it quickly. Small, repeated steps are how the Fed has changed this number before.

Beyond America

Other central banks face the same question. The Swiss National Bank cut its policy rate the day after the Fed's decision, the first major central bank to do so in this cycle, while the Bank of Japan ended negative rates only this week. If the Fed's view of neutral drifts higher, global long-term yields will tend to follow, since Treasuries set the benchmark for pricing debt worldwide. The indicators to watch are the Fed's June projections, real yields on inflation-protected Treasuries and the term premium on ten-year bonds.

The Fed has begun, cautiously, to admit that capital will cost more for longer. The longer-run median will probably keep creeping up in coming projections, and long-dated yields around the world will move up with it, leaving borrowers who expect a return to 2 per cent policy rates disappointed.