The Fed’s Misdiagnosis of the Neutral Rate and the 2026 Policy Mix

 

The Fed’s Misdiagnosis of the Neutral Rate and the 2026 Policy Mix

— Why the Risks of Reaccelerating Inflation and Asset Bubbles Are Rising

 

In December 2025, the Federal Reserve delivered its third consecutive rate cut, lowering the federal funds rate to 3.50–3.75 percent. Markets celebrated the move as confirmation of a successful soft landing, and equity indices surged to new record highs. Yet beneath this wave of optimism lies a deeper and more consequential risk: the possibility that the Fed is underestimating the true neutral interest rate.

 

The Cleveland Fed’s September 2025 Economic Commentary estimates the medium-run nominal neutral rate at 3.7 percent, with a 68 percent confidence interval ranging from 2.9 to 4.5 percent. This estimate stands notably above the Fed’s own Summary of Economic Projections, which places the long-run nominal rate at roughly 3 percent. If the Cleveland Fed’s estimate is closer to reality, then today’s policy rate—3.50 to 3.75 percent—is no longer clearly restrictive. It may already be near neutral or even slightly accommodative.

 

This interpretation aligns with the 2025 Economic Letter from the San Francisco Fed, which argues that the post-pandemic rise in real interest rates is not merely cyclical but reflects a structural upward shift in the neutral rate. Persistent fiscal deficits, a chronically tight labor market, revived investment demand, and the fading of global savings surpluses all point toward the end of the long decline in natural rates that characterized the period from the 1990s through 2020.

 

In other words, a gap may now exist between the Fed’s assumed neutral rate (3 percent) and the economy’s actual neutral rate (closer to 3.7 percent). If the Fed continues easing under the belief that policy remains restrictive, it risks unintentionally shifting into a stimulative stance—rekindling inflationary pressures that had only recently been brought under control.

 

This risk becomes even more pronounced when considering the fiscal dimension.

Public statements have suggested the possibility of distributing tariff revenues directly to American households, with figures such as “$2,000 per household” appearing in media coverage. From an economic standpoint, such a policy would have a dual effect:

• Tariffs raise prices by increasing import costs
• Cash transfers boost demand by increasing disposable income

Combined, these forces would amplify inflationary pressures from both the supply and demand sides.

 

If monetary policy is drifting toward accommodation at the same time that fiscal policy becomes more expansionary and tariffs push up costs, the result is a policy mix that bears structural resemblance to the 1970s:monetary easing × fiscal expansion × cost-push inflation.

 

Markets tend to interpret rate cuts as unambiguously positive, but if the Fed is misjudging the neutral rate, easing may instead fuel a renewed inflation cycle and inflate asset bubbles. Should tariffs and household transfers be implemented simultaneously, the bubble could grow even larger—and the eventual correction correspondingly more severe.

 

What is needed now is not a rush toward further easing, but a reassessment of the neutral rate itself. The question of where the neutral rate truly lies is not a technical footnote. It is the fulcrum on which the trajectory of the U.S. economy in the late 2020s will pivot—toward stability, renewed inflation, or a boom-and-bust cycle of historic proportions.