r* Defined

The neutral rate of interest, aka r-star, or r*, is the real short-term interest rate that:

• Prevails when the economy is at full employment and stable inflation
• Exists when monetary policy isn’t stimulated or restrained by monetary policy
• Is the ‘natural rate of interest’ that aligns supply and demand across the economy
• The benchmark often used by Central banks to set interest rates.

What is today’s  r*?

It’s a question even the Fed can’t easily answer.

As Jerome Powell has acknowledged, r* is a theoretical idea which can never be directly observed. By definition, ‘not directly observable’ is something that can’t be seen, measured or perceived directly by senses or readily available methods, instead inferred or understood only through its effects on observable things.

Determining r* involves use of complex equations that include factors like potential economic growth and determining how fast it can expand without lifting inflation and making assumptions about future economic conditions (remember the old saying about making assumptions?).

Economic Growth

Higher returns to capital that come with faster GDP warrant higher interest rates. Potential GDP is a function of two factors: productivity and labor.

Labor, Productivity & Unemployment

Labor influences overall economic output and inflation expectations. A tight labor market with low unemployment and high wages  can push r* upward due to potential inflationary pressures, while a slack labor market can lower r* due to reduced inflationary concerns.

Labor productivity also factors in. When productivity is high (more output with the same amount of labor), it can contribute to lower inflation. Rapid wage increases in a tight labor market can signal potential future inflation, leading to a higher r* as central banks try to cool the economy. A low unemployment rate often indicates a strong labor market, which can push r* higher due to potential inflationary pressures.

Moving Target

Contributing factors are constantly changing, which is why the Fed relies heavily on the Core PCE Index, and factors in CPI and PPI reports in determining its rate decisions. They “follow the data” and make adjustments at the eight annual FOMC meetings. Read about report differences

Current R Star Rate (until it’s not)

The FOMC’s current estimate of the neutral rate of interest was 1.26% at the end of Q3 2024. Here’s how the Federal Reserve Bank of New York explains Measuring the Natural Rate of Interest.

Isn’t There An App For That?

In fact, there are two models economists use to calculate r*:

Laubach-Williams (LW): A semi-structural model developed in 2001 by economists Thomas Laubach and John C. Williams of the Federal Reserve Bank of New York.

Holston-Laubach-Williams” (HLW): An extension of LW by Kathryn Holston, incorporating additional analysis and features allowing for the application to a wider range of advanced economies and accounting for more complex economic factors like time-varying volatility.

Peer into explainers on these two models and you will quickly find yourself falling down a deep, dark rabbit hole of macroeconomics.

Reaching For The R Star

For those of us simply wishing to know when rates are coming down, and asking why those pulling the levers of our economy are still seeking to clearly define r-star and chart a course to it, the answer is that the FOMC’s only option in determining neutral rate is educated guesswork. As Jermoe Powell put it at a symposium in Jackson Hole in August 2024; “As is often the case, we are navigating by the stars under cloudy skies.”

That may not be the most comforting conclusion, but it is the most accurate.