[BOK Focus] Steady US Economy Ignites Debate on Rising 'Neutral Interest Rate'

Lee Chang-yong "US and South Korea Differ, Cannot Exclude Conflicting Interests"

"Because the neutral interest rate cannot be measured precisely, there is always uncertainty regarding the exact level of monetary policy constraints."

Amid heated debates over the rise of the neutral interest rate based on the robust U.S. economy, Federal Reserve (Fed) Chair Jerome Powell maintained his existing stance on the neutral rate during the Jackson Hole meeting held on the 25th, which has somewhat eased market concerns about a potential increase in the U.S. neutral interest rate. However, as the possibility of a rising neutral rate continues to be raised mainly within the U.S. economic academia, the controversy over the upward adjustment of the neutral rate is expected to persist and influence South Korea's monetary policy as well. If the neutral interest rate rises, the need to operate monetary policy more restrictively increases.

In fact, one of the biggest market interests at this Jackson Hole meeting was Powell’s view on the neutral interest rate. The neutral interest rate is the rate at which the economy neither overheats nor falls into recession, corresponding to the potential growth rate level, representing an ideal rate where economic growth and stable inflation are balanced. If the central bank raises the policy rate excessively above the neutral rate, the economy may slow sharply; conversely, if the policy rate falls short of the neutral rate, inflation cannot be controlled. Therefore, aligning the policy rate close to the neutral rate is a critical task. Since monetary policy shifted its main tool from money supply to interest rates, the neutral interest rate has been used as an important benchmark to assess the stance of monetary policy.

Lee Chang-yong, Governor of the Bank of Korea, is presiding over the Monetary Policy Committee meeting held on the 24th at the Bank of Korea in Jung-gu, Seoul. / Photo by Joint Press Corps

The recent intensification of the neutral interest rate debate stems from sharply divided opinions among economists regarding the direction of the real neutral rate after the pandemic. Olivier Blanchard, a distinguished professor emeritus at the Massachusetts Institute of Technology (MIT) and one of the world’s leading economists, argues that before the pandemic, the neutral rate had been declining due to demographic changes, productivity slowdown, and excess savings, and that it will return to a low level going forward. On the other hand, Larry Summers, professor emeritus at Harvard University, warned in a recent Bloomberg TV interview that the market should watch the impact of the U.S. fiscal deficit, emphasizing that "the neutral rate has risen, is rising, and will continue to rise." Summers also predicted that the policy rate will be raised once or more in the coming months. Currently, the long-term nominal neutral rate, considering the Fed’s 2% inflation target, is estimated at around 2.5% (with a real neutral rate of 0.5%), but he argues it will rise above this level.

The reason for the controversy over the upward adjustment of the neutral rate is that if the real neutral rate also rises amid persistent upside risks to expected inflation, economic management and asset management based on the pre-pandemic low inflation and low interest rate environment will become impossible, leading to asset price revaluation and inevitable volatility expansion. In particular, the possibility of a rising neutral rate in the U.S. suggests a prolonged high interest rate environment, which inevitably affects South Korea’s monetary policy.

Kim Sung-taek, senior fellow at the International Finance Center, said, "Factors that have driven the decline in the real neutral rate, such as potential growth rate influenced by productivity and labor force growth and demographic changes, are weakening, so both downward and upward factors for the real neutral rate coexist." He added, "At Jackson Hole, Powell mentioned that 'the policy rate exceeds the market’s estimate of the neutral policy rate,' which somewhat calmed the market’s concerns about new statements, but uncertainty about the medium- to long-term direction will continue."

[Image source=Yonhap News]

The Bank of Korea is also closely monitoring the U.S. neutral rate upward debate. Lee Chang-yong, Governor of the Bank of Korea, said at a press conference after the Monetary Policy Committee meeting on the 24th, "If the U.S. neutral rate rises, naturally our monetary policy could become more challenging, and the possibility of conflicting interests cannot be ruled out." He added, "When South Korea wants to lower rates considering the real economy, if the U.S. maintains very high rates, we do not necessarily have to follow the U.S., but if there are many effects from changes in monetary policy stances between the U.S. and Korea, especially recent interest rate synchronization, the constraints become greater."

However, Governor Lee noted that South Korea’s situation differs from that of the U.S. He said, "South Korea has experienced fewer structural changes after COVID-19 compared to the U.S., and while the U.S. fiscal deficit has increased significantly, ours remains relatively stable, so it does not necessarily mean the neutral rate must rise as in the U.S." He added, "Due to aging and the long-term slowdown in China’s economic growth rate, there is a possibility that the potential growth rate will decline, so there is a great deal of uncertainty."