In economics there is the idea of the “neutral [interest] rate.”  This is the rate that “keeps inflation and unemployment stable over time.”[1]  There are at least three things to bear in mind about the “neutral rate.” 

First, an unemployment rate of 4 percent is commonly taken as “natural,” while the Federal Reserve Board has a long-term inflation goal of 2 percent.    

Second, “neutral” is the real interest rate that achieves its goals plus the inflation rate.  So, IF 2.0-2.5 percent is the desired real interest rate and inflation is running at 2.0 percent, THEN the “neutral” rate would be 4.0-4.5 percent. 

Third, over the long haul, it is the product of “very slow moving forces: demographics, the global demand for capital; the level of government debt and investors’ assessment of inflation and growth risks.” 

Fourth, it is nebulous.  Essentially, if the current interest rate is not achieving its aim (such as reducing demand or slowing inflation to the target rate), then it isn’t high enough to be “neutral.”  Monetary policy isn’t actually “tight,” regardless of what previous historical rates would suggest or what the Chairman of the Federal Reserve Board says. 

Before the financial crisis of 2007-2009, the Federal Reserve Board had a real “neutral” rate of 2.0-2.5 percent, with an annual inflation rate of 2.0 percent added on for a rate of 4.0-4.5 percent.  After the financial crisis, many parts of the economy de-leveraged.  That is they paid off existing debt and limited borrowing.  The Federal Reserve Board kept interest rates very low for a long time without seeing even their target inflation rate of 2.0 percent.  The shrunken demand for capital facilitated this policy.  Then the government began expanding the deficit during the Covid emergency and afterward.[2]  Demand began to recover, so this began to exert pressure on “real” interest rates held near zero.  Much could change, but “the evidence suggests the public should get used to higher rates as far as the eye can see.” 

            In the 1970s, “poorly conceived regulatory and tax systems” contributed to the substantial inflation.  Government debt amounted to 34 percent of GDP.  The recent (and current) inflation is due to “the government’s gross over-reliance on debt financing to give voters stuff without taxes to pay for it.”  Government debt now amounts to 122 percent of GDP.  In addition, Social Security and Medicare have unfunded obligations of $78 trillion.  The interest rate on the debt has almost doubled, to 2.97 percent.”  Interest payments have “more than doubled, to $985 billion.”  This is larger than the defense budget.”[3]    

            It is easy to argue that this is unsustainable.  The chickens will come home to roost—at some point.  They will arrive in the form of higher taxes on upper income groups and degraded services for lower income groups.  They may hamstring defense spending in a dangerous time.  American politics could get even uglier than they are today.  Hardly seems possible, but….

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[1] Greg Ip, “Higher Rates Not Just for Longer—Maybe Forever,” WSJ, 22 September 2023. 

[2] In early 2020, Federal debt held by the public amounted to 80 percent of Gross Domestic Product (GDP).  Today it stands at 95 percent of GDP.  GDP in 2020 amounted to $20.93 trillion.  Advance estimates of GDP for the third quarter of 2023 project a total of $27.62 trillion.  See: Gross Domestic Product, Third Quarter 2023 (Advance Estimate) | U.S. Bureau of Economic Analysis (BEA)  Eighty percent of 20.93 = $16.75 trillion; Ninety-five percent of 27.62 = $26.24 trillion.  That’s about $9.5 trillion in four years.  A bigger share of a bigger pie. 

[3] Holman Jenkins, Jr., “The U.S. Needs a Defense Buildup,” WSJ, 11 October 2023.