Fed’s new neutral may be one FOMC takeaway

US Federal Reserve’s (Fed) meeting in the week ahead has lost the heat it once had as a likely moment for the central bank’s first interest rate cut – but it could shine a big light on where the Fed thinks the economy is at over the long run.

Conditioned by verbal pushback from Fed officials all year and still-sticky inflation and punchy growth readings, futures markets currently price a near zero chance of a first cut at the March 20 gathering and now favour June or July instead.

And yet the readout from the meeting will be packed with information about what happens next, not least an updated quarterly “dot plot” on policymaker projections and the likely start of discussions on slowing the Fed’s balance sheet runoff.

With many investors reassessing the long-term trajectory of the US economy and whether it’s on a sustainably faster growth path, considerable focus will be on what those Fed dots say about the assumed “neutral” policy rate that neither stimulates nor reins in the economy long term.

Based on their median forecasts, Fed policymakers have left their long-run policy rate assumption basically unchanged since before the pandemic at 2.5%, barring a brief shaving to 2.4% in early 2022 that was quickly reversed.

And as Fed officials assume they will get inflation back to the 2% target one way or another over time, it implies they see a “real” neutral rate of just 0.5% – compared to the current real policy rate of about 2.5%.

A hike in that assumption may not make a difference to whether or even when the Fed starts to cut, as it could cut 200 basis points off rates over the coming two years and still claim to be in a “restrictive” mode bearing down on economic activity and inflation.

But it has potential significance of how much scope the Fed reckons it has over any easing cycle – where it sees a likely “terminal rate” in central bank parlance. And this is why it may be keenly watched by many investors.

The discussion is clearly well underway. Unobservable in real time, the theoretical neutral rate is an ephemeral beast almost impossible to pinpoint until you’ve hit it and – even then – shifting sands of the economy may still shroud it in mystery.

Most Fed officials, including chairman Jerome Powell, claim not to know where it lies exactly.

And yet their best guesses on it should reveal some of what they think is happening under the bonnet of the economy, how restrictive they think the current 5.25% to 5.5% policy rate is right now and where rates may settle once they start an easing campaign.