The day after the Federal Reserve lowered the target federal funds rate a half point in September, major stock indexes soared to record highs.

With inflation moderating, the Fed will likely cut the benchmark rate another quarter point on Thursday, and it’s natural that investors focus on how much further the Fed can cut take rates down.

That sends economists star gazing. We ask what is r* - the neutral real rate of interest?

At r*, the federal funds rate is low enough to maximize employment and encourage enough investment to accomplish potential economic growth and high enough to not enable excessive consumer and business spending that would overheat the economy and accelerate inflation.

The Fed’s 2% inflation target is somewhat arbitrary, and it could settle for something a bit higher if that accomplishes price stability.

The latter occurs when anticipated inflation is low enough to not appreciably alter household or business decisions. Consumers don’t rush to spend today to avoid higher prices tomorrow, and businesses aren’t reluctant to invest because falling prices during periods of slack demand could make loans difficult to service.

According to Fed policymakers’ projections, inflation should ultimately settle at 2.0% and the federal funds rate at 2.9%. That would put r* at 0.9%.

Such an end point for the federal funds rate won’t leave much room to cut interest rates during the next economic crisis. During easing cycles going from the 1960s through COVID, the federal funds rate was lowered an average of 5.3 percentage points.

Indeed, the Fed’s notions and econometric estimates of r*, and hence where the federal funds rate should settle when inflation hits target, has been falling for decades.

The natural rate is determined by many factors.

Potential economic growth, which depends on productivity and labor force growth. Higher potential growth would encourage more entrepreneurial risk taking, increase business investment and boost r*.

Set interest rates too low, and businesses will overinvest and accelerate inflation, and households won’t save enough to finance investment and government deficits.

Demographics. Declining birth rates have reduced indigenous labor force growth in recent years, lowering potential growth and r*. Longer life expectancies and potential years of productive employment should increase the funds needed for retirements and capacity to lay those up, also lowering r*.

Risk aversion. If households pile into safe assets like Treasuries and CDs, this will drive up the pool available for savings no matter the rate of return and drive down r*.

As we emerge from COVID, several factors are coalescing to now raise r*. The Fed may be overestimating how low r* may be and how much the federal funds rate may be lowered without accelerating inflation.

Artificial intelligence is greatly increasing the demand for capital. The huge sums being spent on processors, servers, data centers, the electrical grid and software to create, for example, AI agents should considerably boost productivity growth.

With President Joe Biden, the surge in immigration increased the labor force and potential economic growth above what would have been permitted by indigenous population growth and the immigration regime enforced under President Donald Trump. That increases r*.

After the Global Financial Crisis, households, burned by too much speculation, became both more risk adverse and needed to deleverage (rebuild their balance sheets after taking big losses).

We were emerging from that process when COVID hit, and these days investors are embracing riskier investments—in particular stocks and among wealthier investors private credit funds.

The federal deficit is now 7% of GDP—the highest in peacetime level other than during the GFC and COVID shutdowns and even higher than during the Great Depression. That taxes the pool of available savings and raises r*.

The econometric models maintained by the New York Federal Reserve Bank put r* at about 1%, but those can’t possibly capture all these complex changes in real time.

Some independent analysts are putting r*, as it applies to the real federal funds rate policy, closer to 2%.

Splitting the difference puts r* at about 1.5%. Assuming a rate of inflation between 2 and 2.5 percent places the end point for a federal funds rate that encourages potential economic growth without accelerating inflation between 3.5% and 4.0%

Chairman Jerome Powell is inclined to look past estimates of r* and as data comes in, to simply try to balance “the risk of tightening monetary policy too much against the risk of tightening too little”. He may find the federal funds rate he can tolerate to be appreciable higher than 2.9%.

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Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.