Understanding ‘R-Star’ – The Fed’s Real Neutral Interest Rate

In the realm of macroeconomics, the concept of R-Star (r*) plays a vital role in determining the appropriate interest rate setting for central banks. This crucial tool assists in achieving price stability, and, in certain cases, also targets maximum employment. For central banks like the Federal Reserve, understanding and applying R-Star helps in crafting monetary policies that avoid both overheating and excessive cooling of the economy.

R-Star is the estimated real rate at which the economy operates optimally, neither overheating nor cooling off excessively. This real equilibrium interest rate serves as a benchmark for the central banks. If core inflation is exactly at the target, the nominal neutral rate aligns with this standard. In the context of the United States, this rate is typically around 1%. Therefore, if inflation aligns perfectly with its target, the nominal neutral rate would stand at 3%.

However, given that inflation has run above target levels for several years, and considering the Fed Funds rate is presently at 4.25%, the Fed appears to be engaging in a somewhat restrictive policy, positioning the current rate above the neutral benchmark.

Key Factors Influencing R-Star

Various factors are considered by central banks, such as the Federal Reserve, when calculating R-Star. These factors influence the equilibrium rate, helping to provide a clearer understanding of economic conditions:

• Demographics: The size and growth of the labor force significantly impact potential economic growth. A larger workforce often correlates with stronger potential growth, which, in turn, suggests a higher equilibrium rate. Conversely, a smaller workforce might indicate a lower equilibrium rate.
• Productivity: The efficiency with which capital and labor are utilized also affects the equilibrium rate. Enhanced productivity implies a higher equilibrium rate due to efficient use of resources, whereas lower productivity suggests a lower rate.
• Availability of Risk-Free Assets: The supply of risk-free collateral, like Treasury securities, plays a role in determining R-Star. An abundant supply typically implies a higher equilibrium rate, while a limited supply suggests a lower rate.

Recent insights from the Federal Reserve’s minutes reveal that some FOMC members believe the R-Star has increased. This viewpoint is influenced by the ongoing use of government deficits, which boosts the supply of Treasury collateral, and advancements in AI-driven productivity, both contributing to an upward shift in the equilibrium rate.

This adjustment in the perceived neutral rate would mean the current 4.25% Fed rate might not be as restrictive as once thought. Instead, the neutral rate could be seen closer to 3.50%, reflecting these broader economic shifts and inputs.

Understanding R-Star is essential for both policymakers and investors, as it plays a critical role in shaping monetary policy and predicting future economic conditions. Recognizing the factors that influence R-Star helps in anticipating central banks’ potential responses to economic developments, aiding in informed investment and policy decisions.