What Is R-Star?
R-star, or the natural real rate of interest or neutral rate, is an important but unobservable rate that determines whether the current policy rate setting is accommodative, neutral or restrictive when the economy is at full strength and inflation is stable.
A Taylor-type monetary policy rule would recommend setting the policy rate equal to r-star plus 2%, the Fed's inflation target, assuming the U.S. output gap and inflation gap were close to zero. Setting the Fed's benchmark fed funds rate above r-star would cool the economy while setting it below r-star would stimulate it.
The long run trend in the real rate of interest is driven by fundamental factors such as labor productivity growth, the growth of the labor force, the supply and demand for savings and investors' desire for safe assets. (See: MNI: Central Banks Should Beware Of Chasing Higher R-Star - BIS)
What's the Fed's Estimate of R-Star?
The Laubach-Williams and Holston-Laubach-Williams models, co-created by New York Fed President John Williams, provide quarterly estimates of r-star and related variables. It has been falling over time and has hovered between 0.5% and 1% since the financial crisis.
The alternative Lubik-Matthes model by Richmond Fed economist Thomas Lubik and Indiana University professor Christian Matthes is computed using a more flexible economic framework and has estimated a much higher r-star. (See: MNI INTERVIEW: Richmond Fed's R-Star Estimate Rises to 2.3%)
Each FOMC member submits his or her own projection of the natural rate every quarter. That median estimate of the "longer run fed funds rate" has declined over time but rebounded slightly since Covid. (See: MNI POLICY: Lively Debate At Fed Over Possible R-Star Rise)
Has Covid Lifted R-Star?
New York Fed President Williams said in 2023 that estimates for the U.S. and other advanced economies indicate “there is no evidence that the era of very low natural rates of interest has ended.”
But Fed officials have been careful to say there's a lot of uncertainty around r-star estimates. The resilience of the U.S. economy in the face of very rapid rate hikes after Covid suggests r-star may be higher than thought, they've noted.
Even before Covid, Fed Chair Jerome Powell has called for caution in using r-star as a guide for setting monetary policy. At the Fed’s 2018 Jackson Hole conference, he said: "assessments of the values of the stars are imprecise and subject to further revision. To return to the nautical metaphor, the FOMC has been navigating between the shoals of overheating and premature tightening with only a hazy view of what seem to be shifting navigational guides."