How economists assess monetary policy

How economists assess monetary policy

During the Federal Open Market Committee's July 28–29 meeting, the committee voted 9 to 3 to maintain the target range for the federal funds rate at 3.50% to 3.75%. The decision arrived against a divided outlook, with three policymakers preferring a 25-basis-point increase and the full committee continuing to weigh solid economic growth, steady labor market conditions and inflation that remains above the Federal Reserve's 2% goal.

The split does not mean monetary policy has reached neutral. Most estimates place the current federal funds rate at a restrictive level, indicating that policy continues to exert some degree of restraint on economic activity. What remains unsettled is how much restraint is still needed to bring inflation fully back to target, particularly when Chairman Kevin Warsh reiterated in his press conference that the Federal Reserve's inflation target remains 2%.

The Federal Reserve's current framework defines 2% inflation, measured by the annual change in the personal consumption expenditures (PCE) price index, as most consistent with its mandate for maximum employment and price stability.

Estimating an unobservable neutral rate

Economists assess the stance of monetary policy by comparing the federal funds rate with the neutral rate, often referred to as r-star. The neutral rate is the level of interest rates that neither stimulates nor slows economic activity when the economy is at full employment and inflation is stable.

The challenge is that r-star cannot be directly observed. Unlike the federal funds rate, which is set by the Federal Reserve, the neutral rate must be estimated from economic data and inferred through models. Some approaches emphasize long-term trends in economic growth, productivity and demographics, while others place more weight on financial markets and observed economic behavior.

Because assumptions differ, estimates vary across institutions and over time. Federal Reserve officials typically evaluate a range of plausible outcomes rather than relying on a single estimate. Current estimates generally place the federal funds rate above neutral, though that conclusion depends on uncertain estimates of r-star and broader evidence from financial conditions, inflation and economic growth.

Has r-star moved higher? Structural changes since the pandemic

One of the most important debates in monetary policy is whether the neutral rate itself has increased in recent years. For much of the decade following the Global Financial Crisis, economists generally believed the neutral rate was relatively low, reflecting modest economic growth, aging demographics and a high global demand for savings. Those conditions helped support a period of low interest rates and low inflation.

Since the pandemic, however, some economists have argued that the neutral rate may have moved higher. A combination of large fiscal deficits, increased infrastructure spending, reshoring efforts, energy investment and rapid deployment of artificial intelligence has raised expectations for future economic growth and capital demand. If businesses and governments are investing more aggressively, higher interest rates may be required to balance saving and investment across the economy.

If r-star has moved higher, the current federal funds rate may be exerting less restraint than traditional estimates suggest. That would affect how policymakers interpret inflation, growth and labor market data as they assess the path for interest rates.

The Taylor Rule as a secondary check

The Taylor Rule gives economists a secondary check by linking interest-rate recommendations to inflation and economic activity. When inflation is above target or demand appears too strong, the rule generally points to higher rates. When inflation is falling and growth is weakening, it typically points lower.

Economists often compare Taylor Rule outputs with neutral-rate estimates. If the measures point in the same direction, they can reinforce the policy assessment. If they diverge, they highlight uncertainty about the appropriate stance.

Looking for evidence in financial conditions and economic data

Financial conditions provide another way to evaluate whether policy is reaching households and businesses. Economists track Financial Conditions Indexes, which combine information from interest rates, credit spreads, equity market performance and lending standards into a single measure of how easy or difficult it is to access capital. These conditions can tighten or loosen independently of changes in the federal funds rate.

Incoming data adds the real-economy check. Progress toward the 2% inflation target remains a key indicator, but policymakers also evaluate growth, labor market conditions and credit availability to assess whether higher rates are slowing demand.

What investors should watch after the latest rate decision

The latest Federal Reserve meeting matters, but the market impact may depend more on what it signals about the path ahead. By holding rates steady while stressing that the 2% inflation target is unchanged, the committee gave investors a framework for evaluating Treasury yields, credit spreads and the risk-free rate used in many asset valuation models.

For fixed-income investors

• Treasury yields may remain sensitive to inflation data and expectations for future rate cuts.
• If the neutral rate has moved higher, long-term Treasury yields may settle above pre-pandemic levels.
• Credit spreads can show whether tighter policy is slowing activity.

For equity investors

• Treasury yields serve as the risk-free rate in many valuation models.
• Higher risk-free rates generally weigh on valuations by raising the discount rate applied to future cash flows.
• Lower rates can support valuations, especially for assets with expected cash flows further in the future.

Investors can apply the same questions economists use: Where does the neutral rate stand? How tight are financial conditions? And is the economy responding to higher interest rates as expected?

Final thoughts

The question of how restrictive monetary policy remains arrives at a moment of transition for the Federal Reserve. Chairman Warsh has emphasized the importance of reassessing how policymakers measure inflation and evaluate economic conditions, while also making clear that the central bank's inflation target remains 2%.

For the Federal Reserve, progress toward 2% inflation remains essential, but it does not answer every question about whether policy is neutral, restrictive or accommodative. Policymakers still need to evaluate the broader set of signals that show how interest rates are affecting growth, credit conditions and financial markets.

To learn more about how changes in monetary policy may affect your balance sheet or strategy, contact your Citizens Private Bank relationship manager. Our team can help you evaluate what changing interest-rate conditions may mean for your liquidity, borrowing needs and broader balance sheet strategy.