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short essays and reports on the economic issues of the day
2004 ■ Number 28

A Neutral Federal Funds Rate?
Richard G. Anderson, Jason J. Buol, and Robert H. Rasche
he stance of monetary policy with respect to aggregate
demand is widely measured in terms of the Federal
Reserve Open Market Committee’s (FOMC) federal
funds rate target. Too low a target, it is suggested, will cause
the Open Market Desk to inject too much liquidity, “overstimulating” aggregate demand and increasing the inflation
rate. Too high a target will result in undue pressures on liquidity, unnecessarily high market interest rates, and slower-thandesired economic activity. Like Goldilocks exploring the three
bears’ forest home, many analysts appear to believe there exists
a “just right,” or neutral, target between the two extremes. But
what exactly is a neutral monetary policy and is it possible to
achieve it?
A neutral level of the federal funds rate often is discussed
as having two properties. First, it is a level that neither stimulates nor slows output relative to potential. Second, it is a moving target that varies from one period to another. But such a
characterization raises an interesting question: If the neutral
rate changes frequently, can it be measured accurately and
does the concept have any value for policymakers?
Arguments for the existence of a steady-state neutral federal
funds rate frequently begin with the assertion that the historical record suggests bounds for the neutral rate, say, greater
than 1 percent and less than 10 percent, and that the task is
to narrow that range, perhaps to a single number. One oftmade claim is that the neutral rate, in the long run, should
equal the sum of the growth rate of potential real GDP plus
the target inflation rate. The Congressional Budget Office
projects that real potential GDP will grow at approximately
a 3.1 percent rate during 2004-05, with similar growth rates
in later years. If measured inflation is to be in the neighborhood of 2 percent with no expectation of an increase or
decrease, then a neutral funds rate target might be slightly
greater than 5 percent.
This analysis, however, does not allow for the typical
upward slope of yield curves—that is, for a positive term
premium. Macroeconomic steady-state growth models
often assume a horizontal yield curve, thereby excluding
such a premium. In financial markets, however, yields on
longer-term assets typically are higher than those on shorterterm assets. To estimate a neutral overnight federal funds


rate target, we need to isolate the maturity-related term premium from the inflation-related risk premium that is included
in longer-maturity yields as a result of uncertainty regarding
future inflation. One possibility is to observe maturity-related
Treasury rate spreads during a period when market participants
expect future inflation rates to be approximately unchanged
from their then-current pace. The figure shows the rate spread
between the 10-year Treasury constant-maturity yield and the
bond-equivalent yield on 3-month Treasury bills. It seems
likely that the inflation-uncertainty risk premium was approximately zero during the early 1960s and the mid-1990s, suggesting a maturity-related rate spread of approximately 150 to
200 basis points. Subtracting this spread from the previous 5
percent rate suggests a neutral overnight federal funds rate of
approximately 3 to 31/2 percent.
Recent public statements by FOMC members have suggested a range for a neutral funds target of between 31/2 and
51/2 percent. Allowing for the typical positive slope of the
yield curve suggests that the neutral federal funds target is
more likely to be near the lower than the upper end of this
range. ■

Slope of Treasury Yield Curve
10-Year Constant Maturity Minus 3-Month T-Bill
Percentage Points






Views expressed do not necessarily reflect official positions of the Federal Reserve System.