December 2025 Monthly: The Great Japan-US Neutral Interest Rate Debate: Who's in Trouble (Due to Inflation and Bubbles)—the Federal Reserve or the Bank of Japan?

 

December 2025 Monthly: The Great Japan-US Neutral Interest Rate Debate: Who's in Trouble (Due to Inflation and Bubbles)—the Federal Reserve or the Bank of Japan?

 

Monday, December 15, 2025

Summary:

 

In December 2025, the market is reveling in the story of a "successful soft landing."

 

The Federal Reserve has repeatedly cut interest rates, stock prices are hitting new all-time highs almost every day, and the Bank of Japan is finally beginning serious discussions about raising interest rates. At first glance, it appears that the post-COVID-19 turmoil is on the way to resolution.

 

However, beneath this comforting story lies a structural risk that is being overlooked: the possibility that both the Federal Reserve and the Bank of Japan, the two major central banks, have incorrectly estimated the "neutral interest rate."

 

The neutral interest rate is more than just a technical term.

 

It is the very axis of monetary policy: "At what interest rate level will the economy neither overheat nor cool down and put it on a stable track?" If this coordinate axis is misaligned, no matter how cleverly the timing of interest rate cuts and hikes is discussed, policies will push the economy in unintended directions.

 

In this article, we will examine:

• How the Fed's underestimation of the neutral interest rate is becoming the "starting point" for a re-acceleration of inflation and the amplification of bubbles;

• And how the Bank of Japan has forced itself into an even more hopeless situation than the Fed, along with the policy mix for 2026-27.

 

The question is not "should we cut or raise interest rates?"

 

The question is a more fundamental choice: "What neutral interest rate should we assume to design the economy for the second half of the 2020s?"

 

① The Fed's Achilles' Heel Exposed by the "Divided Rate Cut Decision"

 

The Nikkei editorial published on Friday, December 12th, "Divided Rate Cut Decision Tests the Fed's Credibility," accurately describes the divided opinions within the FOMC and the growing political pressure, and is generally persuasive.

 

However, the editorial does not delve into a more fundamental problem—the Fed's long-standing "Achilles' heel."

 

As I have long pointed out, the Fed's Achilles' heel is its continued arbitrary assumption of a neutral interest rate of 3% nominal.

 

■ The Fed's assumptions implicitly imply a "nominal growth rate of 3.9%"—a world that is far too low

 

In its Secular Economic Outlook (SEP), the Fed assumes the following long-term assumptions:

• Inflation rate: 2%

• Real GDP growth rate: 1.9%

 

Adding these two together, the Fed sees a long-term nominal GDP growth rate of 3.9% for the U.S.

 

However, over the 45 years since 1980, the average U.S. nominal GDP growth rate has been 5.8%. Compared to historical performance, the Fed's assumptions are far too conservative and underestimate the potential of the U.S. economy.

 

■ A 3% neutral interest rate leads to a pessimistic conclusion: a 1% real growth rate

 

If the Fed continues to maintain a nominal neutral interest rate of 3%, and assumes a 2% inflation target, wouldn't that implicitly view the long-term real growth rate of the U.S. as only 1%?

 

This is unconvincing given the historical dynamism of the U.S. economy.

 

From the perspective of internal consistency, it is also inconsistent with the long-term real growth rate of 1.9% indicated by the Fed's SEP.

 

■ The true neutral interest rate should be "around 4%."

 

If the Fed's long-term nominal growth rate is 3.9%, then it would be natural for the neutral interest rate to also be 3.9%, or "around 4%," which is easier for Americans to understand.

 

Despite this, the Fed continues to cling to an arbitrary 3% rate. This erroneous premise is the biggest factor distorting current policy decisions.

 

■ The latest rate cut has already begun to fall below "neutral."

 

The latest rate cut brings the policy interest rate to 3.75%. While this is a positive real interest rate that satisfies the Taylor principle, unlike the Bank of Japan, it is beginning to fall below the true neutral interest rate (around 4%) and is entering monetary stimulus territory.

 

If the Fed continues to insist on a neutral interest rate that is too low at 3%, it could cause the following risks to be priced into the market:

• Established expectations of rate cuts toward 2026 and 2027

• Reaccelerating inflation expectations

• Overheating of asset prices

This could ultimately lead to further inflation and a resurgence of the bubble.

 

■ The rate cut cycle already began in August 2024

This rate cut cycle did not begin in 2025.

In fact, it began with a speech on August 23, 2024, at the annual summer Jackson Hole Symposium in Wyoming, where Chairman Powell stated, "It's time to adjust policy."

 

Since then, the policy rate has been cut by a cumulative 1.25 percentage points, but the 10-year Treasury yield has actually started to rise.

 

This is evidence that the market is beginning to suspect that the Fed's rate cuts will reignite inflation, suggesting that this "split rate cut" may have accelerated the decline in the Fed's credibility.

 

■ (Reference) Key Points Identified in the Nikkei Editorial

The Nikkei editorial points out short-term and institutional issues, including:

• Disagreements within the FOMC

• Uncertainty due to statistical delays

• Increasing political pressure.

 

However, these are merely superficial phenomena; underlying them lies a structural distortion in the Fed's estimate of the neutral rate, which it has not revised for many years.

 

■ Conclusion: It is not the "split rate cut" itself that is undermining the Fed's credibility.

 

The real issue is not the split in the decision to cut this rate, but rather the structural problem of an underestimation of the neutral rate, which is leading to misguided policy decisions and eroding market confidence.

 

As long as the Fed continues to rely on internally inconsistent assumptions, the risks of a resurgence of inflation expectations and asset bubbles will only increase.

 

② The Fed's Misdiagnosis of the Neutral Rate and a Dangerous Policy Mix in 2026

--How to Interpret the Risk of a Reacceleration of Inflation and a Bubbles

 

As noted in the previous section, on Wednesday, December 17, 2025, the Federal Reserve implemented its third consecutive interest rate cut, lowering the U.S. policy rate to 3.50-3.75%.

 

The market interpreted this as a "successful soft landing," and the stock market continued to reach new record highs every day after the FOMC meeting, at least until last weekend.

 

Behind this optimism lies a significant risk that is being overlooked: the possibility that the Fed is underestimating the neutral rate. We will explain this point in more detail below.

 

For example, in its September 2025 Economic Commentary, the Cleveland Federal Reserve estimated the medium-term nominal neutral rate to be 3.7%. Furthermore, the 68% confidence interval widens to 2.9% to 4.5%, suggesting a clearly higher level than the "3.0% long-term interest rate" indicated in the Fed's Summary Economic Outlook (SEP).

 

If this estimate is close to reality, the current policy rate of 3.50% to 3.75% is no longer "tightening" but is likely approaching neutral or already in slightly accommodative territory.

 

This point is consistent with the San Francisco Fed's April 2025 letter, which characterized the rise in real interest rates after the pandemic as a sign of a structural rise in the neutral interest rate, rather than a "temporary" one.

 

Permanent fiscal deficits, a tight labor market, a recovery in investment demand due to the AI ​​boom, and a weakening global savings glut. These factors are converging to bring to an end the "long-term downward trend in the natural rate of interest" that has continued since the 1990s.

 

In other words, there may be a gap between the Fed's assumed neutral interest rate (3%) and the actual neutral interest rate (around 3.7%).

 

If the Fed continues to cut rates without recognizing this gap, policy will unintentionally lean toward "accommodative" policy, re-stimulating inflationary pressures.

 

An even more powerful policy factor could be added to this situation.

 

The Trump administration has reportedly discussed a plan to return tariff revenues to American households, with the figure of "$2,000 per household" being touted. Economically, this would have the following dual effect:

• Tariffs push up prices (cost push).

• Subsidies boost demand (demand stimulus).

 

If fiscal policy moves in this expansionary direction at a time when monetary policy is tilting below neutral, inflationary pressures will be doubly amplified.

 

This is structurally similar to the policy mix of the 1970s: monetary easing, fiscal expansion, and cost push.

 

Markets tend to jump to the conclusion that "rate cuts = relief," but if the Fed has misdiagnosed the neutral rate, a rate cut would actually lead to a resurgence of inflation and an exacerbation of asset bubbles.

 

Furthermore, if tariffs and subsidies are combined, the bubble would inflate even more, and the subsequent correction would be even more severe.

 

What is needed now is a reassessment of the neutral rate, rather than intoxication with the expectation of rate cuts. The neutral rate the Fed adopts is not merely a technical issue; it is a fundamental question that will determine the trajectory of the U.S. economy in the second half of the 2020s: stability, reinflation, or a bubble and bust.

 

③Reevaluation of the BOJ's neutral interest rate is inevitable—a comparison with the Fed reveals a "no-way-out" situation.

 

The Bank of Japan's monetary policy meeting, to be held this week on the 18th and 19th, is one of the most important events in financial markets in December 2025, rivaling last week's FOMC meeting.

 

Following Governor Ueda's December 1st speech, in which he stated, "We would like to make an appropriate decision on whether or not to raise interest rates," the market has almost fully priced in an additional 0.25% rate hike. However, the real focus of this meeting is not simply whether or not there will be a rate hike.

 

The focus is on the "pace of interest rate hikes in 2026" and the BOJ's "redefinition of the neutral interest rate." It is also concerning that Governor Ueda already stated in a press conference after his speech that he would like to "clarify" the neutral interest rate more clearly.

 

This remark suggests that the lower end of the previously excessively broad "1.0% to 2.5%" range may be raised.

 

If the lower bound were raised to 1.25% or 1.5%, the expected number of rate hikes in 2026 would likely increase from one to two. This would be a clear negative for the stock market.

 

1. The Bank of Japan's Neutral Interest Rate is Underestimated

 

The government and the Bank of Japan largely share the following assumptions: inflation target: 2%; potential growth rate: real: around 0.6%. Adding these two together, a nominal neutral interest rate of approximately 2.6% is a natural estimate.

 

However, the Bank of Japan has set its neutral interest rate unnaturally low and broad, ranging from 1.0% to 2.5%.

 

Furthermore, the reality is that inflation has exceeded 2% for 43 consecutive months, and inflation is currently settling at around 3%.

 

Despite this, the Bank of Japan has continued to avoid reevaluating the neutral interest rate.

 

2. Crucial Difference from the Fed: Whether to Make the Neutral Interest Rate the "Axis of Policy"

 

The Fed places the neutral interest rate at the center of its policy decisions. As detailed in the previous section, the SEP explicitly states the long-term interest rate.

 

For example, regional Federal Reserve banks have proactively published estimation models, bringing the discussion to the forefront by 2025, such as:

o San Francisco Fed: Possible increase in neutral interest rate

o Cleveland Fed: Nominal neutral interest rate of 3.7%

 

On the other hand, the Bank of Japan:

• Almost never publishes estimates,

• The range is too broad to be used for policy decisions,

• Continues to claim that the "neutral interest rate is 1% to 2.5%" even when inflation is 3%,

• Continues to "tolerate" accelerating inflation since April 2022.

 

In other words, the Bank of Japan has not made the neutral interest rate the axis of its policy.

 

3. The Result: The Bank of Japan is in a "no-way" situation even more severe than the Federal Reserve.

 

As a result, the following structural chain of events is occurring:

 

1) Underestimation of the neutral interest rate → Chronically low interest rates → Weak yen and import inflation

 

2) "Wait-and-see" approach even when inflation is 3% → Always delayed interest rate hikes

 

3) Excess liquidity stagnates in asset markets → Bubble-like behavior

 

For the Federal Reserve, a strong dollar suppresses import inflation, while for the Bank of Japan, a weak yen amplifies inflation.

 

As a result, Japan is at greater risk of falling into the triple whammy of inflation, currency depreciation, and bubbles than the Federal Reserve.

 

4. The BOJ's December Policy Meeting Could Become a "Japanese Version of a Neutral Interest Rate Shock"

 

If the BOJ raises the lower bound on the neutral interest rate:

• Increased number of rate hikes in 2026

• Increased pressure for the yen to appreciate

• Stock market adjustment pressure

• Increased volatility in the government bond market

 

Conversely, if the BOJ leaves the rate unchanged:

• Inflation will become entrenched

• Yen depreciation will continue

• The risk of asset bubbles expanding will increase.

 

5. Conclusion: The BOJ Must Not Avoid Redefining the Neutral Interest Rate

 

The Federal Reserve appears to be actively reevaluating the neutral interest rate and making it the core of its policy. The BOJ has underestimated the neutral interest rate and its policy decision-making criteria remain unclear.

 

As a result, Japan is falling into a situation with even more no-way-out potential than the Fed. This meeting has the potential to mark the beginning of a "redefinition of Japan's interest rate system itself."

 

Tomo Nakamaru

Former World Bank Economist

Supplementary Discussion: Neutral Interest Rate and Its Trends

 

① What is the Neutral Interest Rate?

 

Below, we will summarize the similarities, differences, and policy implications of the neutral interest rate, natural interest rate, and potential growth rate, taking into account their structural and historical contexts.

 

What the Three Concepts Have in Common

 

All of these are theoretical benchmarks for measuring the "basal temperature" of the economy.

• Because they are "unobservable," they rely on estimation models.

• They measure the balance between economic supply (productivity and population) and demand (investment and consumption).

• They are used as a benchmark for determining the "optimal level" of monetary and fiscal policy.

• In the long term, they are strongly dependent on productivity, demographics, and technological progress.

•

In other words, all three are "shadow indicators" for measuring the "state in which the economy is neither overheating nor stagnating."

 

The Difference Between the Neutral Interest Rate and the Natural Interest Rate

 

While often treated as nearly synonymous, they have distinct nuances.

 

✅ Natural Rate (Wicksellian Natural Rate)

• Defined by Wicksell

• The real interest rate that stabilizes prices

• The interest rate at which the economy is at full employment and inflationary pressures are zero

• A more "theoretical and structural" concept

• Strongly dependent on long-term supply-side factors (productivity and population)

 

✅ Neutral Rate

• An operational concept used by modern central banks

• A real interest rate that neither stimulates nor discourages the economy

• Close to the natural rate, but more "practical" for policy management

• Also reflects the output gap and financial conditions (risk premiums, financial intermediation)

 

🔸 Difference in a nutshell:

Natural Rate = Theoretical "Pure" Equilibrium Interest Rate

Neutral Rate = The "Practical" Equilibrium Interest Rate Used in Policy Decisions

 

Relationship to Potential Growth Rate

The potential growth rate is the growth rate an economy can achieve without causing inflation.

• Productivity (TFP)

• Labor input (population and labor force participation rate)

• Capital stock

 

Relationship with the Natural Interest Rate and Neutral Interest Rate

The natural interest rate is said to be determined in the long term by r* and other factors. As the potential growth rate g increases, the natural interest rate also increases.

In other words,

• Countries with high potential growth rates have high natural interest rates and neutral interest rates.

• Countries with low potential growth rates have low natural interest rates and neutral interest rates.

 

Japan's natural interest rate has been declining over the long term precisely because of a decline in its potential growth rate (population decline and stagnant productivity).

 

The relationship between the three can be visualized as follows:

Concept: What it represents; How it is determined; Relationship to policy

 

Natural rate: The real interest rate that stabilizes prices; Productivity, population, and time preference; Theoretical standard

Neutral interest rate: The real interest rate that neither stimulates nor inhibits the economy; Natural rate + financial environment; Practical standard for monetary policy

Potential growth rate: The growth rate that can be achieved without causing inflation; Labor, capital, and productivity; Determines long-term supply capacity

 

Evaluation from a historical and institutional perspective

 

✅ ① Wicksell's natural rate is a concept based on the premise of "monetary neutrality."

• Money is neutral in the long run, and interest rates are determined by the real economy.

• It is based on different assumptions from the modern financial system (credit creation and risk premiums).

 

✅ ② The neutral interest rate is "institution-dependent."

• The efficiency of financial intermediation

• Risk premiums

• Regulation

• International capital flows

 

✅ ③ The potential growth rate is the "story of society's productivity."

• Technological innovation

• Demographic structure

• Education

• Culture and institutions

• Corporate investment attitudes

 

Because it is determined by a complex combination of these factors, it is not simply an economic indicator but reflects society's structural "vitality."

 

Policy implications: The three concepts are a "policy compass."

• Central banks determine their monetary policy stance based on the difference between the neutral interest rate and the real interest rate.

• Governments consider structural reforms to raise the potential growth rate.

• The two influence each other.

o If the potential growth rate rises, the natural interest rate also rises, expanding the scope for monetary policy.

o Conversely, if the potential growth rate is low, interest rates will be stuck at the zero lower bound, eliminating policy space.

Japan's secular stagnation is a prime example of this chain of events: "low potential growth rate → low natural interest rate → ineffective monetary policy."

 

Summary: These three concepts represent the "three economic horizons."

• Natural interest rate: The theoretical "pure equilibrium."

• Neutral interest rate: The "practical equilibrium" of policy management.

• Potential growth rate: Society's "long-term vitality."

 

These three concepts are intertwined and shape the current, medium-term, and long-term horizons of the economy.

 

 

①  Trends in the Neutral Interest Rate

 

Below, we will summarize the evolution of the Federal Reserve's (FRB) assessment of the neutral interest rate (r*) from the 1980s to 2025, taking into account historical background and institutional changes.

 

1. 1980s: High Interest Rates and the Shadow of the "Neutral Interest Rate"

 

In the early 1980s, the United States was in the midst of Volcker's inflation-fighting efforts, with the policy interest rate reaching 20%.

• The term "neutral interest rate" was rarely used in policy discussions at the time.

• The FRB's sole focus was "controlling inflation."

• Real interest rates were high, and the natural interest rate was presumed to be high as well (strong population and productivity growth).

Evaluation: While the neutral interest rate was not explicitly stated, this was effectively an era of a high natural interest rate.

 

2. 1990s: The Greenspan Era - The concept of the neutral interest rate emerged in policy discussions.

 

The 1990s were an era of the IT revolution and rising productivity.

• The concept of the "neutral interest rate" gradually began to be used within the Federal Reserve.

• However, no official estimates existed yet.

• Real interest rates began to decline (signals of a global savings glut).

Assessment: The neutral interest rate is thought to have begun to decline gradually from high levels.

 

3. 2000s: The natural interest rate declined significantly (the emergence of the Laubach–Williams model).

 

In 2003, the Laubach–Williams (LW) model emerged, and estimation of the natural interest rate (r*) was institutionalized within the Federal Reserve.

• The natural interest rate continued to decline throughout the 2000s.

• Background: Population aging, weakening investment demand, and a global savings glut.

• The Federal Reserve recognized that the "neutral interest rate has been declining over the long term."

Assessment: The neutral interest rate fell from the 2-3% range to the 1% range.

 

4. 2010s: Zero Interest Rate Era and "Ultra-Low Neutral Rate"

 

After the Lehman Brothers collapse, the federal funds rate fell to 0.25%.

• The Federal Reserve declared that the "neutral rate is at a historically low level."

• Even in the LW model, r* fell to around 0%.

• Interest rate hikes since 2015 have been explained as "limited room for further hikes due to the low neutral rate."

Evaluation: The neutral rate was estimated to be near zero, severely limiting the scope for monetary policy.

 

5. 2020-2022: Pandemic → Inflation Soars → Reevaluation of the Neutral Rate

 

After the pandemic, inflation soared, and the Federal Reserve rapidly raised interest rates.

• Discussion within the Federal Reserve about whether the neutral rate was rising intensified.

• Real interest rates also rose.

• During the 2022-2023 rate hike phase, the neutral rate was often estimated to be in the high 1% to 2% range.

Assessment: The neutral interest rate has risen from zero.

 

1.    2023-2025: The Fed's Official Position - "The Neutral Interest Rate May Be Rising"

 

The 2025 San Francisco Fed Letter clearly stated that "real interest rates have risen since the pandemic, and the neutral interest rate may be rising as well."

• Downward pressure from the aging population has weakened.

• Budget deficits are pushing up real interest rates.

• Downward pressure from global factors has also weakened.

Assessment: The Fed itself suggests that the neutral interest rate has begun an upward trend.

 

2.    The Fed's "Longer-Run Interest Rate" as of 2025

 

The "longer-run" interest rate (nominal) published by the Fed's FOMC remains stable at around 3%.

• This is the Fed's official view of the nominal neutral interest rate.

• Subtracting the 2% inflation target, the real neutral interest rate is around 1%.

Evaluation: The Fed's official view for 2025 is that the real neutral interest rate will be around 1%.

 

3.    Summary of 1980-2025: The neutral interest rate has "reversed its long-term decline and then reversed course."

 

Period Neutral Interest Rate Trend Background

1980s High level: High inflation and high growth

1990s Gradual decline: Productivity changes and the beginnings of a global savings glut

2000s Clear decline: Aging population and declining investment demand

2010s Near zero: Post-Lehman stagnation

2020–22 Signs of an increase: Inflation surge and fiscal expansion

2023–25: The Fed hints at an upward trend: Changes in global factors and fiscal deficits

 

The evolution of the neutral interest rate is not simply a financial indicator; it reflects structural changes in society. • 1980s: Inflation and population growth

• 2000–2010s: Aging, stagnation, and a global savings glut

• 2020s: Budget deficits, geopolitics, and a resurgence of inflation

 

In other words, the neutral interest rate is a mirror that reflects changes in the economy's underlying structure.