When the European Central Bank's Governing Council convenes on 10 September, it is widely expected to raise the deposit rate by a further 25 basis points. The immediate decision looks well signalled. The harder question is what the path beyond that looks like, and the answer depends on a number that no central banker can directly observe.

The invisible benchmark

Economists call it r-star: the neutral rate of interest, the theoretical level at which monetary policy neither stimulates nor restrains the economy. Below it, policy is accommodative. Above it, policy is restrictive. The concept shapes every rate decision the ECB makes, because it defines the boundary between easing and tightening. Yet r-star cannot be measured in real time. It can only be estimated from observable data, and those estimates shift as conditions change.

Goldman Sachs currently places the euro area's nominal neutral rate at roughly 2.7 per cent. The bank acknowledges that the plausible range around this estimate is unusually wide, reflecting the inherent difficulty of the calculation. Even so, 2.7 per cent sits well above the ECB's own published long-run rate assumption of 2 per cent, the figure embedded in staff macroeconomic projections. That gap, roughly 70 basis points, is not a rounding error. It changes how the stance of monetary policy should be assessed.

Signs the neutral rate has shifted

Three developments point toward a higher r-star. Euro area output has been running above estimated potential, meaning the economy is producing beyond its sustainable capacity without generating the inflationary surge that earlier tightening cycles might have provoked. Unemployment across the currency union sits at historically low levels, a signal that labour markets are tighter than the structural benchmarks many models assume. Credit demand has held up, with businesses and households continuing to borrow despite the cumulative increase in rates already delivered.

An economy that keeps expanding, hiring and borrowing while the central bank tightens is an economy where the neutral rate may well have moved up. The resilience itself is the evidence. If rates were genuinely restrictive, growth would be slowing, unemployment would be rising and credit would be contracting. None of that has materialised in the way past experience would predict.

Financial conditions blunting the transmission

The other side of the story is that financial conditions have not tightened as much as the policy rate alone would suggest. Equity prices have risen, lowering the cost of capital for firms that raise money in public markets and easing balance sheet constraints more broadly. A weaker euro has provided a competitive boost to exporters, but it also pushes up import prices, working against the ECB's disinflationary objective.

Both dynamics mean that the headline deposit rate overstates the degree of restriction actually being felt across the euro area economy. The ECB has raised rates, but the transmission mechanism has been blunted by forces outside its direct control. Policy looks tighter on paper than it does in practice.

Implications for the ECB's rate path

If the neutral rate is higher than the ECB's 2 per cent assumption, and if financial conditions are looser than the policy rate implies, then the current stance of monetary policy is less restrictive than it appears. That lowers the threshold for further tightening. Goldman's own terminal rate forecast, the level at which it expects the ECB to stop raising rates, stands at 2.5 per cent. If r-star is closer to 2.7 per cent, then a 2.5 per cent terminal rate would still be accommodative rather than restrictive. The ECB would have room to go further.

The ECB's own long-run estimate of 2 per cent, if taken at face value, would suggest that rates are already well into restrictive territory. But if that estimate is outdated, the entire framing shifts. Policy that looks tight against a 2 per cent neutral rate looks neutral or even loose against a 2.7 per cent one. The distance between where rates are and where they need to stop depends entirely on where the goalposts sit.

The limits of estimation

None of this makes further tightening inevitable. The ECB has stressed repeatedly that its decisions are data-dependent. A deterioration in any of the indicators supporting the higher r-star thesis would change the calculus. Labour markets could soften. Credit conditions could tighten with a lag. Business and consumer confidence could falter. The neutral rate itself is not a fixed parameter: it reflects structural forces such as productivity growth, demographic trends, global savings patterns and risk premia. A shift in any of these could push it lower again.

The practical difficulty is that r-star becomes visible only in retrospect. Central bankers are steering towards a destination they cannot see, adjusting course based on whether the economy appears to be overheating or stalling. If the neutral rate has moved and the ECB continues to calibrate policy against an outdated 2 per cent assumption, it risks two errors: tightening too little and allowing inflation to become embedded, or tightening too much and pushing the economy into an unnecessary downturn.

Organisations

European Central Bank · Goldman Sachs