Fed Rate Hike Suddenly on the Table as Neutral Interest Rate Rises

The Federal Reserve's recent decision to hold its benchmark rate steady at 3.50%, 3.75% has sparked a new question in the market: how did we get to a world where the Fed's next move might be up?

For two years, the only question was when the Fed would cut interest rates. But with three regional Fed presidents voting against the hold and instead calling for an immediate rate hike, it seems that scenario is no longer on the table.

The surface story behind this shift in sentiment is the persistence of inflationary pressures, including rising energy costs, tariffs, AI-driven demand for power and chips, and deficit-financed government spending. These factors have created a perfect storm of price increases that are expected to continue into the coming months.

However, the deeper story is that the 'resting rate' may have risen, meaning that the neutral interest rate, the level at which the economy runs normally with stable inflation and full employment, has increased. According to estimates from the Cleveland Fed, the real neutral rate has climbed from 0.8% in 2021 to around 1.5% today.

This shift is attributed to two forces draining the supply of saving: government borrowing and the fading foreign savings glut. Meanwhile, AI-driven demand for investment is swelling, pushing up the clearing rate. As a result, the Fed's current rate of 3.50%, 3.75% is now sitting around neutral, meaning that a rate cut would actually be counterproductive in this environment.