Fed officials emphasize that their decisions depend on economic data, solid evidence of the economy’s health and its possible direction. But there is one key concept guiding the Fed that Chairman Jerome Powell says is “theoretical” and “cannot be directly observed.”

This is the so-called ‘neutral interest rate’, an interest rate level that neither stimulates nor dampens the economy. The Fed’s most important tool is its key interest rate, which affects borrowing costs throughout the economy, and functions by either stimulating demand when rates are low or cooling demand when rates are high. That depends on whether the Fed faces high inflation, which forces the Fed to slow the economy, or high unemployment, which forces the Fed to do the opposite.

Economists describe the neutral interest rate as theoretical because it depends on many, many factors that make it too inaccurate – such as population growth, productivity, savings behavior, any structural changes in the economy and so on, in addition to the effects of borrowing. costs.

With inflation down substantially from a four-decade peak reached in 2022 and just a fraction away from the Fed’s 2% target, the Fed has shifted more attention to the U.S. labor market, which has has been steadily weakening for years. The economy is still in good shape, but Powell cabled in September that the Fed is determined to maintain its strength and avoid any deterioration.

Fed officials have said they believe borrowing costs are still at restrictively high levels, endangering the labor market. Now it’s a matter of how quickly the Fed wants interest rates to return to that neutral interest rate. Of course, that also depends on inflation. Some officials have said they feel no urgency to lower rates.

“I’m in no rush to become neutral,” Atlanta Fed President Raphael Bostic said at an event in Jackson, Mississippi, last month. “We need to get inflation back to our 2% target, and I don’t want us to get to a point where inflation comes to a standstill because we haven’t been restrictive long enough. So I will be patient.”