ECB Faces Neutral Rate Conundrum Ahead of September Rate Decision

The European Central Bank is facing a challenge in setting interest rates as the neutral rate of the euro area, also known as r∗r^*, has become elusive. This rate is the equilibrium interest rate that keeps an economy growing near its potential while inflation remains at target.

According to Goldman estimates, the euro area's nominal neutral rate is around 2.7%, with a wide range of possibilities. However, current policy does not appear particularly restrictive due to growth above potential, historically low unemployment, and resilient credit demand.

The ECB's decision on September 10, which is expected to be a 25 basis point increase, is not the primary concern. The more critical issue is whether the euro area's neutral rate has shifted higher, leaving the ECB with room to tighten before monetary policy starts to have a braking effect.