With the December decision approaching, the Federal Reserve is experiencing the most serious divergence on neutral interest rates in over a decade!

The Federal Reserve is facing the most severe divergence on neutral interest rates since 2012 after cutting rates by more than a percentage point, and this controversy is influencing the policy direction this month.

At the September FOMC meeting, 19 officials provided 11 different estimates, ranging from 2.6% to 3.9%—the latter being close to the current rate level. The debate over where the "neutral interest rate" actually lies fundamentally reflects policymakers' deep divisions on whether the economy needs more stimulus.

Federal Reserve Chairman Jerome Powell has acknowledged that there is a "strong divergence" among the rate-setting committee on prioritizing price stability versus maximizing employment. The core issue is: Does the economy need more momentum to support the labor market, or should it hit the brakes due to inflation being above target and tariffs potentially pushing prices higher?

This divergence is transforming into a rare public debate: Should rates be cut again next week, and how should actions proceed thereafter? The neutral interest rate—defined as the rate level that neither stimulates nor suppresses the economy—is seen as the endpoint of the rate-cutting cycle, but the Federal Reserve is currently struggling to find this target position.

As the benchmark rate approaches the upper limit of the neutral interest rate estimates, each rate cut decision becomes increasingly difficult. Philadelphia Fed President Anna Paulson stated on November 20 that the dual risks of inflation and unemployment, coupled with rates possibly nearing neutral levels, have made her cautious heading into the December meeting.

Divergence Reaches Historical Extremes

Estimates of the neutral interest rate among Federal Reserve officials have shown the greatest divergence since predictions began being published in 2012. Stephen Stanley, Chief U.S. Economist at Santander Bank, stated:

"Our personnel opinions are scattered all over the place. While there has always been some degree of divergence in this area, the current range is wider."

Stanley believes that as the Federal Reserve's benchmark rate reaches the upper limit of the estimate range, these estimates become increasingly important.

"For some of the more hawkish Fed members, it may start to become a binding constraint," he said, "which absolutely means that each subsequent rate cut will become increasingly difficult."

Philadelphia Fed President Paulson, while explaining her cautious stance, noted: "Monetary policy must walk a fine line. Each rate cut brings us closer to the point where policy shifts from slightly suppressing economic activity to starting to provide a boost."

The neutral interest rate, also known as r-star, based on the mathematical symbol used in models, or the natural rate of interest, is a concept that cannot be directly observed but can only be inferred, and has sparked intense debate for over a century. Although some economists, including Keynes, have questioned its actual usefulness, few modern central bank officials share this view.

New York Fed President John Williams, an expert in the field, believes this concept is at the "core of monetary theory and practice." Williams pointed out that failing to diagnose changes in the natural or neutral interest rate and unemployment rate could have far-reaching consequences, citing examples from the inflation expectations surge in the 1960s and 1970s The neutral interest rate is widely believed to be driven by long-term factors such as demographic structure, technology, productivity, and debt burden, which influence saving and investment patterns.

Since the neutral interest rate is to economists what "dark matter" is to astronomers — not directly observable — some decision-makers prefer to judge it "by its effects," as Powell puts it.

St. Louis Fed President Alberto Musalem stated that low default rates indicate that the financial environment still supports the economy. Cleveland Fed President Beth Hammack pointed out that the narrowing credit spread means that monetary policy "is only barely restrictive, even if it is restrictive."

However, extracting clues from financial markets is not easy. Some Federal Reserve officials view the 10-year U.S. Treasury yield hovering around 4% as evidence that the financial environment is not dragging down the economy. Others believe that these indicators reflect expectations about the economic path and strong global demand for safe assets, thus being of little use in estimating the neutral interest rate.

Future Direction of the Neutral Interest Rate Also Divided

In addition to the lack of consensus on the current level of the neutral interest rate, there are also divisions within the Federal Reserve regarding its direction.

Minneapolis Fed President Neel Kashkari predicts that the widespread application of artificial intelligence will lead to faster productivity growth, and as new investment opportunities boost capital demand, the neutral interest rate will rise.

Federal Reserve Governor Stephen Miran, a recent appointee by Trump, believes that current policies should also be included in the discussion. In his first policy speech after joining the Fed, Miran suggested that Trump's tariffs, immigration restrictions, and tax cuts collectively pushed the neutral interest rate lower, even if only temporarily — therefore, the Fed should significantly ease policy to avoid harming the economy.

Williams expressed skepticism last month about incorporating short-term changes into calculations. He believes that global trends such as an aging population are keeping interest rate valuations at historically low levels.

Actual Data Remains the Basis for Decision-Making

Given the uncertainty surrounding the outlook, the divisions over the neutral interest rate are unlikely to disappear when Fed officials release their latest estimates next week.

Former Philadelphia Fed President Patrick Harker, who retired this year, stated that more specific factors — "labor data and price data" — will drive actual policy decisions. Harker said:

“The neutral interest rate is a useful conceptual tool, but it is just a tool and does not drive policy decisions. I don’t recall a time when everyone sat together and the entire conversation was about what r-star is."

Additionally, the Federal Reserve will see a leadership change in 2026, with Trump vowing to select a new chair committed to lowering interest rates, and there may be other opportunities to place allies within the Fed. New decision-makers are expected to advocate for looser monetary policy like Miran and may estimate the current neutral interest rate to be lower