MNI INTERVIEW: Richmond Fed's R-star Estimate Rises To 2.3%

A model of the U.S. neutral real rate of interest developed by Richmond Fed economists indicates r-star has risen by nearly two percentage points since the pandemic to a significantly higher level than the Laubach-Williams model more commonly cited in Fed deliberations, Thomas Lubik of the Richmond team told MNI, adding fodder to the debate over whether the era of rock-bottom rates is over.

The Lubik-Matthes natural rate of interest climbed to 2.3% in the second quarter from a low of 0.4% in 2020 while the Laubach-Williams estimate, which uses a different methodology, has neutral little changed from pre-pandemic levels at 0.6%, Lubik said in an interview. The two measures of the inflation-adjusted level of interest rate that neither spurs nor slows growth had tracked each other closely for two decades before the pandemic. The FOMC's latest median projection is 0.5%, which would imply that the Fed funds rate is now at restrictive levels.

Using virtually the same raw data, Laubach-Williams imposes a tight relationship between output growth and the real interest rate whereas the measure developed by Lubik and former colleague Christian Matthes in 2015 is "largely atheoretical," Lubik said, making no restrictions on how variables interact.

"Our model takes strong signal from the real rate of interest -- the nominal fed funds rate minus expected inflation. For the longest time there wasn’t much action in that series. The real rate was negative and flat," he said. Then Covid hit and the real interest rate began to fall, sinking to its lowest since 1975, according to the Lubik-Matthes measure, before rebounding rapidly once the Fed began raising rates and inflation came down.

"It performed remarkably well during Covid, because it had the internal structural ability to adapt to extreme volatility in data," Lubik said. "This is why the model was built -- to react quickly to structural change."

COVID MODIFICATIONS

That innate flexibility however also generates more volatile estimates of r-star. That's at odds with the idea that central banks have little influence over the neutral rate, which is determined by deep, long-running trends, Lubik said. "What we’re seeing now is our model isn’t out of the Covid years yet, so to speak."

To address that, he and Matthes recently made some specification changes to draw a slower moving trend, so as to not "overinterpret" recent data, Lubik said. "Without the specification change, it would have estimated an r-star of 2.65%. After smoothing the estimates more, we still have 2.3%."

The New York Fed made some Covid-era adjustments to its Laubach-Williams estimates as well. Publication of the measure was suspended in November 2020 and resumed only earlier this year. Still, despite strong recent GDP growth, the Laubach-Williams model finds the main longer-term consequence of the pandemic to be a reduction in trend output growth.

"Both approaches are well grounded in academic literature," Lubik said. "Theoretical models have a harder time processing rapid changes, whereas economists have a ready-made toolkit for situations where there are big changes -- the time varying parameter."

SOMEWHERE IN THE MIDDLE

These divergent estimates of r-star out of the Fed underscore the uncertainty surrounding the neutral rate, so key to central banking frameworks yet unobservable. The median projection by Fed officials remains at 0.5%, though estimates have been drifting higher in recent quarters. Chair Jerome Powell has notably downplayed the use of r-star in setting policy. (See: MNI INTERVIEW: More FOMC Members Set To Raise R-Star-Rosengren and MNI POLICY: Lively Debate At Fed Over Possible R-Star Rise)

One could think of the two models as "the outer edges of the r-star measures," Lubik said. "If you add a measure -- a market-based measure of real interest using the 5-year, 5-year forward inflation expectation rate -- this is actually over the last couple years right in the middle between our two measures."

"A plausible measure of r-star is 1.5% -- above Laubach-Williams and below ours," Lubik said. The neutral rate has likely risen due to rising government deficits and a reversal of the global savings glut as China's current account surplus shrinks, he said. "This is where I see my priors."