AEI economist Michael Strain argues the economy’s strength despite higher rates suggests the neutral federal funds rate—one that neither stimulates nor restricts growth—is significantly higher than the Fed's ~3% estimate. This implies current monetary policy may not be as restrictive as widely believed.

The Fed raised its estimate of the long-run 'neutral' interest rate—the rate that balances the economy. This technical shift means current interest rates are now considered less restrictive than previously thought, providing an underlying justification for the Fed to pursue more rate increases to achieve its desired cooling effect.

A strong argument suggests that robust economic spending combined with weak labor growth points to higher productivity, potentially from AI. Because productivity gains are disinflationary over the long term, this could give the Fed justification to lower interest rates now without worrying as much about current inflation levels.

At 4.325%, the current Fed Funds rate is right at its 70-year median. This historical context, combined with large fiscal deficits, supports a contrarian view that monetary policy is actually accommodative or neutral, not restrictive as often claimed.

Contrary to the idea that AI justifies rate cuts, the boom is likely increasing the neutral rate of interest (R-star). By stimulating corporate investment and household consumption, AI creates upward pressure on rates, which limits the Federal Reserve's ability to ease monetary policy.

The Federal Reserve describes its policy as removing "a dose of accommodation," not making conditions restrictive. This analogy of easing off the accelerator, rather than braking, suggests the central bank believes the economy can withstand further rate hikes, making them more probable.

The economy's resilience to rate hikes suggests the Fed's estimate of the neutral rate (R-star) is too low. The current model is overly influenced by the "extraordinary period" after the 2008 financial crisis. The true neutral nominal rate is likely closer to 4%, meaning current policy is still accommodative.

The podcast highlights a contradiction in the argument that an AI productivity boom justifies rate cuts. Standard economic theory suggests that higher productivity increases the economy's potential, raising the equilibrium interest rate (R-star). To prevent overheating, the Fed should theoretically raise, not lower, its policy rate.

Technological revolutions like AI boost productivity, which increases the neutral interest rate (r-star). Central banks that cut policy rates below this new, higher r-star risk creating asset bubbles and inflation, a mistake former Fed Chair Greenspan made during the dot-com boom, according to economist Paul Samuelson.