While the decline in the neutral real fed funds rate in recent years can be explained in part by the decline in potential GDP growth, there are other factors, including increased risk aversion, higher costs of financial intermediation and higher savings. Fed Chair Janet Yellen is right that, at least in the short-term, the neutral real rate is probably closer to zero. If we allow for the lower equilibrium rate, assuming inflation averages 2.0%, that would put the nominal neutral fed funds rate at around 2.0%, below the Fed’s medium-term estimate of 2.9%. Nevertheless, it is worth stressing that the actual fed funds rate is still well below that neutral rate, so monetary policy is undoubtedly very loose. We expect rising inflation to prompt the fed to raise the fed funds rate to between 1.25% and 1.50% by end-2017 and to between 2.25% and 2.50% by end-2018.
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