It's hard to say exactly where the neutral point in monetary policy is. It has to be data driven.

We know that neutral rates have traditionally in the U.S. economy been positive. And they have changed as technology changes, as savings change, as government deficits change. So we really have to look at the dynamics of the economy and try to move monetary policy in a manner that allows us to get the potential growth and allows us to sustain this price stability era.

If the economy evolves as I expect over the next year or so - with continued output growth, steady increases in employment, and reasonably low inflation - then I expect we will continue to move the federal funds rate toward neutrality at a measured pace.

The precise course the Fed takes very much depends on the precise course the economy takes. As I have said before, if signs of price pressure emerge on a consistent basis, we will need to consider quickening the pace at which we move toward policy neutrality.

Recognizing how difficult it is to know when policy is truly neutral, I think it is prudent to move the federal funds rate up to a position that gives me more confidence that monetary policy is no longer accommodative. I would prefer this strategy to finding out the hard way—for example, through a deterioration in inflation expectations or in the inflation picture itself—that we had maintained an overly accommodative stance for too long.

Although the basic direction of policy has been more obvious than usual for the last year or so, it will likely become less clear and perhaps more difficult to communicate as we approach the equilibrium or neutral interest rate that is consistent with economic activity at its potential and with low and stable inflation.

Looking ahead, I expect real GDP growth to be in the neighborhood of 4 percent for 2005. Given this scenario, the Fed should continue moving monetary policy toward a neutral stance at a measured pace and thus keep inflationary pressures well-contained.

"Based on the core personal consumption price index, the historical equilibrium real funds rate averaged 2.67 percent from 1966 first quarter to 2003 fourth quarter,'' Parry said in an e-mail response to a question.

``Since the growth of productivity is running considerably higher than the average for that period, I assumed that a reasonable range for the equilibrium real rate would be 2.5 percent to 3.5 percent. I also assumed a reasonable estimate for inflation expectations would be a core PCE inflation rate of 1 percent to 2 percent.

``Therefore, the range for the nominal natural rate would be between 3.5 percent (2.5 percent real and 1 percent inflation) and 5.5 percent (3.5 percent real and 2 percent inflation)."

From a Bloomberg News column

As for the level of the natural rate, it is higher than it has been in some of the past forecasts, although as I noted it drifts down over time as the wealth-to-income ratio drifts down. I think the height is a result of the fact that the wealth-to-income ratio is a lot higher than we thought it was--or thought it was going to be a year or two ago--given what has happened to the stock market. Demand has been much stronger. In effect the experience, in terms of the level of the wealth-to-income ratio and the strength of demand at previous interest rates, has led us to think that the natural or equilibrium rate is a lot higher than we used to believe and a lot higher perhaps than it has been in history. If the strength of demand for producers’ durable equipment and so forth persists, the saving rate, even if it is creeping up, is going to be lower than it has been historically, and then the natural real rate will be high relative to history.