The European Central Bank (ECB) is now just two interest rate cuts away from reaching what is considered the neutral rate.
According to research published by European Central Bank (ECB) economists on Friday, the neutral interest rate range for the eurozone economy is estimated between 1.75% and 2.25%. This range is deemed neither stimulative nor restrictive for economic growth. If the deposit rate is lowered two more times by 25 basis points each, it could potentially reach the upper limit of this range. Most investors and analysts believe that the midpoint of 2% will be the level at which rates ultimately stabilize.
This research marks the final phase of the ECB's rate-cutting policy. The bank has already implemented five rate cuts in this cycle as inflation trends downward toward the 2% target. After the latest cut in January, ECB President Christine Lagarde indicated that officials would "base" their policy stance on this paper. However, some colleagues have since raised questions about the practical application of the neutral rate.
The neutral rate range identified by economists is below the current key rate of 2.75%. Policymakers have suggested that further cuts may be considered at the upcoming meeting. However, they emphasized that the neutral rate should not be seen as a precise guide for future key rates, as economic activity changes will also influence rate settings as constraints gradually ease.
ECB economists Claus Brand, Noemie Lisack, and Falk Mazelis stated that while these estimates provide supplementary information for monetary policy decisions and assist in communicating policy stances, they should not be viewed as rigid measures of appropriate monetary policy. Decisions on policy implementation must rely on a comprehensive analysis of data and its macroeconomic impacts, rather than depending on any single alternative measure.
Previously, ECB Chief Economist Philip Lane identified nine factors that determine whether key rates are binding, including the maturity structure of household and corporate debt and changes in the global government bond market. He stressed that all these factors must be integrated into the calibration of monetary policy and cannot be summarized solely by the neutral rate.
Lagarde also downplayed the role of the neutral rate in determining the extent of rate cuts. She mentioned that while staff will work on model research, they will consider various information and intelligence, opting for a flexible judgment rather than relying solely on model outcomes.
Determining the neutral rate is complex, with economists employing various estimation methods. Factors influencing the neutral rate may include demographic changes, productivity growth rates, the ease of international trade, and climate change. ECB economists acknowledged that current estimates for the neutral rate are "highly uncertain."
On the other hand, before the COVID-19 pandemic, Bank of England economists estimated the neutral rate for the UK to be between 2% and 3%. However, they noted on Thursday that this rate may have risen by 25 to 75 basis points since then. Federal Reserve officials generally considered the neutral rate to be around 2.5% or lower before the pandemic.
Since the neutral rate cannot be directly observed, economists estimate it through various methods. The ECB indicated that updated models through the end of 2024 show the neutral rate to be between 1.75% and 2.25%, while other metrics point to a broader range of 1.75% to 3%. Despite an upward revision in estimates in the post-pandemic environment, current estimates remain significantly lower than pre-global financial crisis levels.
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