The neutral rate is the theoretical central bank interest rate target that would neither restrict nor fuel activity in an economy at full employment. Assessments of the neutral rate, also known as R-star, are essential to policy-setting.

Vanguard’s neutral-rate estimate is about half a percentage point higher than the estimate produced by the Laubach-Williams model, the Fed’s most frequently cited neutral rate source, named for its economist authors. We ran our higher neutral-rate assessment through the Fed’s macroeconomic model under a range of monetary policy rules. The results suggested that the median effective rate target would peak at 6% in 2023. The Fed’s current rate target is 5%–5.25%.

In the longer term, the median central bank target rate would need to settle at 3.5%, or a full percentage point higher than the median long-run outlook in the Fed’s most recent Summary of Economic Projections. These “higher for longer” findings support the idea put forth by Joe Davis, Vanguard’s global chief economist, in his January Wall Street Journal commentary (subscription required) suggesting that long-term investors stand to benefit from a new era of “sound money.”

The views below are those of the global economics and markets team of Vanguard Investment Strategy Group as of July 19, 2023.

Our 10-year annualized nominal return and volatility forecasts are shown below. They are based on the March 31, 2023, running of the Vanguard Capital Markets Model® (VCMM). Equity returns reflect a 2-point range around the 50th percentile of the distribution of probable outcomes. Fixed income returns reflect a 1-point range around the 50th percentile. More extreme returns are possible. 

The most recent inflation and labor reports suggest some cooling in the economy ahead of a July 26 monetary policy announcement by the Federal Reserve.

• The Consumer Price Index rose 3% on a year-over-year basis in June, down from 4% in May. Core prices, which exclude food and energy, were 4.8% higher, down from 5.3% the month before. However, the path to the Fed’s 2% inflation target is likely to be long and winding. We expect year-over-year core inflation to finish 2023 around 3.3%, and that it will not fall below 2% until 2025.
  
• Employers added 209,000 jobs in June, the fewest since December 2020, when there were net job losses. But the unemployment rate fell to 3.6%, within the 3.4%–3.7% range that has prevailed since March 2022. Wage growth remained strong—average hourly earnings were up 4.4% year-over-year in June—as the demand for workers continues to outstrip labor supply. We believe that gives Fed policymakers impetus to raise their target for short-term interest rates by 25 basis points (0.25 percentage point) on July 26.
  
• At its last monetary policy meeting, on June 14, the Federal Open Market Committee voted to pause its interest rate hiking cycle, holding its rate target to a range of 5%–5.25%. In its “dot plot,” an aggregation of Fed officials’ individual views, the Fed suggested its rate target would be 5.5%–5.75% by year-end. That’s 25 basis points above our 5.25%–5.5% forecast range.

Official data released on July 17 put an exclamation point on China’s relatively weak economic performance. Gross domestic product (GDP) grew 6.3% in the second quarter compared with a year earlier, but that was a percentage point below analysts’ consensus estimate. Although growth topped the first quarter’s 4.5% pace, it owed in large part to favorable year-earlier comparisons. More telling: Compared with the first quarter, GDP grew just 0.8%.

• We recently lowered our full-year growth forecast to a range of 5.5%–6%. Uncertainties around meaningful policy stimulus pose a downside risk not only to our forecast but also to the government growth target of “around 5%.” Developments at the Politburo meeting scheduled for the end of July will say a lot about the potential for further downside.
  
• “We anticipate further stimulus measures to remain relatively modest,” said Grant Feng, a Vanguard senior economist. “That could take the form of expanded policy bank financing for high-end manufacturing and the green sector, a modest policy rate cut of 10 to 20 basis points, and further relaxation of housing purchase restrictions.”
  
• Consumer prices fell for a third consecutive month in June and were flat compared with a year earlier. Producer prices, meanwhile, were down by a greater-than-expected 5% year-over-year in June. We foresee full-year headline inflation in a range of 1%–1.5% and core inflation, which excludes food and energy prices, of 1%.

Weak recent data, especially from Germany, the euro area’s largest economy, suggest that a recession continued between April and June, marking a third consecutive quarterly contraction.

• “Weakness in the euro area has been broad-based across manufacturing and services,” said Shaan Raithatha, a Vanguard senior economist. “That’s consistent with another mild quarterly contraction in GDP, which would extend the recession.”
  
• We expect the peak impact of monetary policy tightening to take hold in the second half of 2023, with the labor market weakening in the European Central Bank’s (ECB’s) continuing quest to bring inflation to its 2% target. We continue to anticipate full-year economic growth of 0.5%, though risks are now skewed to the downside.
  
• The pace of both headline and core inflation, which excludes energy, food, alcohol, and tobacco prices, stood at 5.5% on a year-over-year basis in June. We believe that still-too-high inflation will lead the ECB to raise its deposit facility rate by a further 25–50 basis points to a peak of 3.75%–4%, with no rate cuts until mid-2024.
  

Learn more: In a recent video (2:48), Vanguard’s European chief economist, Jumana Saleheen, discussed how interest rate increases required to bring inflation back to target are likely to weigh on growth in the second half of 2023.

A day after government data showed an unexpected rise in core inflation, the Bank of England (BOE) on June 22 announced a 50-basis-point (0.5 percentage point) increase in the bank rate, to 5%. We recently raised our forecast for the BOE’s peak rate by 75 basis points to a range of 5.5%–5.75%, given the stronger-than-expected inflation data, a continued tight labor market, and accelerating wage growth. We maintain our view that the BOE will not lower its rate target until mid-2024 at the earliest.

• “The U.K. has had the worst of both worlds when it comes to inflation,” said Shaan Raithatha, a Vanguard senior economist. “Its labor market has faced challenges like those in the United States, with lingering COVID-related supply issues, and its energy-price shock has been worse than in the euro area, given domestic price-setting mechanisms. That’s why the Bank of England still has work to do to get inflation down toward target.”
• We expect year-over-year core inflation, which excludes food and energy prices, to end the year at around 4.9% and to average 5.3% in the fourth quarter, still well above the BOE’s 2% target.
• We foresee zero economic growth for the full year. Our base case is for recession in 2023, though the likelihood has increased that recession may be delayed into 2024. Resilience is partly attributable to changes in the U.K. mortgage market since the 2008 global financial crisis. Fewer households hold mortgages today, and among those that do, more have rates that are fixed for 2 or 5 years rather than variable. As such, higher interest rates take longer to affect households. 

Emerging markets led the global rate-hiking cycle. As tighter monetary policy conditions cause economies to slow and help inflation recede toward central bank targets, we expect emerging markets to lead the rate-cutting cycle as well. That development could play out this month in Chile, where minutes of the June meeting of Banco Central Chile indicate the possibility of multiple rate cuts this year.

• “Chile’s central bank is likely to be the first in Latin America to cut rates,” said Vytas Maciulis, a Vanguard economist. “Inflation, though still high, has fallen consistently, inflation expectations have dropped to the bank’s 3% target, and the broad economy has faltered.”
• The Bank of Mexico left the target for its overnight interbank rate unchanged at 11.25% in June. The rate target remains more than 7 percentage points higher than where it stood when the bank’s hiking cycle began in June 2021. We believe the bank is likely to have reached its rate peak but don’t anticipate rate cuts in 2023.
  
• We anticipate global emerging markets growth of 3.9% in 2023, but the recent economic developments in China, the world’s second-largest economy, bear watching. We foresee emerging Asia leading the way with 2023 growth of around 5.25%. We anticipate growth of about 1.5% in Latin America and of around 1% in central Europe, the Middle East, and Africa.

When the Bank of Canada (BOC) raised its overnight rate target to 5.0% on July 12, it cited a familiar theme: “The accumulation of evidence that excess demand and elevated core inflation are both proving more persistent.” Since the start of its hiking cycle in March 2022, the BOC has raised its overnight rate target by 4.75 percentage points.

• We believe the BOC has reached its peak rate target, though risks skew to the upside. “Of particular note is the role of immigration within the labor and housing markets,” said Asawari Sathe, a Vanguard senior economist. “The immigrant share of the population is at its highest level in decades, and that’s keeping both labor supply and housing demand strong.”
• The Canadian economy created 60,000 jobs in June, three times expectations and the most since January 2023. Even as the employment rate rose, so did the unemployment rate, to 5.4%, as more people sought work. We expect unemployment to edge up to about 5.5% by year-end as monetary policy slows the economy.
  
• We expect inflation (+2.8% at the headline level, year-over-year, in June but +3.6% excluding food and energy) to continue to moderate this year. Upside risks remain, however, in part because shelter costs remain high in a home loan market dominated by variable-rate and short-term fixed-rate loans.
  
• We continue to foresee 2023 economic growth of less than 1%, with risks to the downside, and a recession late in the year as the effects of higher interest rates spread.
  

A change at the top is unlikely to significantly alter the policy approach of the Reserve Bank of Australia (RBA). The government announced on July 14 that Michele Bullock would replace Philip Lowe as governor when Lowe’s seven-year term expires on September 18.

• We’re watching developments related to interest-rate targeting as potentially more significant than the leadership change. A recent recommendation of an external review of the RBA would clarify the bank’s inflation target as the midpoint of the current 2%–3% range. “Assuming this recommendation is implemented in 2024, as widely expected, this adds a hawkish tilt to RBA policy so long as inflation remains above target,” said Alexis Gray, a Vanguard senior economist.
  
• While the RBA left its cash rate target unchanged at 4.1% on July 4, we expect above-target inflation to spur the central bank to raise its cash rate target to 4.6% and leave it there at least until 2024.
• Headline inflation registered its smallest increase in 13 months in May, up 5.6% compared with a year earlier. Excluding food, automotive fuel, and holiday travel, prices were 6.4% higher in May. We expect headline inflation to fall to around 4.5% by year-end, as higher interest rates dampen demand, and to reach the RBA’s 2%–3% target in late 2024 or 2025.
  
• We continue to expect economic growth of 1%–1.5% for all of 2023, though risks skew to the downside. Our proprietary leading indicators model suggests that growth will fall below trend in the coming quarters amid weak consumer confidence and subdued consumption. We assign about a 40% probability of recession over the next 12 months. 

• Investor Pulse: Many expect strong returns to continue (article, issued July 2023)
• Why the Fed will not cut rates this year (article, issued June 2023)
• A midyear update on our economic and market outlook (package of articles and videos, issued June 2023)