R-Star: Why It Matters Right Now
In September, the Federal Open Market Committee (FOMC) voted unanimously to increase the Federal Funds rate by 75 basis points for the third consecutive meeting. The FOMC has now increased short-term interest rates by three percentage points since March 2022 to the highest since 2008. These moves are a reaction to the historically strong inflation we’ve seen in the US economy post-pandemic. The committee hopes that by increasing interest rates they can slow economic growth enough for inflationary pressures to ease.
How far to increase interest rates is now the question facing policymakers. They want to increase rates enough to slow inflation, but not so far that the economy contracts. The middle ground is what has been referred to as a “soft landing” for the economy. As the FOMC tries to find this soft landing they will be guided by familiar incoming economic data, like the Consumer Price Index and unemployment rate. However, the committee will also be guided by an economic concept you may be less familiar with: the neutral rate of interest, or R-star.
R-star is the real or inflation-adjusted interest rate that keeps an economy in equilibrium where there is full employment in the labor market and inflation is stable. The term R-star comes from how this neutral interest rate is denoted in economic models – r*, read as “R star”. This concept is more than 100 years old, but it has gained prominence since the early 2000s. When real interest rates are above R-star, the economy slows, inflation falls, and unemployment rises. On the other hand, when real interest rates are below R-star, the economy accelerates, inflation rises, and unemployment falls.
If we knew where R-star was, then monetary policy would be simple. Unfortunately, we can’t derive R-star precisely from financial or economic data. We can estimate it, though. A specific economy’s R-star is thought to be largely dependent on its level of savings and, to a lesser degree, other factors like the pace of productivity growth and demographics. These factors obviously vary over time; thus, R-star is a moving target.
Estimates of R-star in developed economies, like the US, have been trending down since the 1970s. This may have been driven by several factors including the slow growth in productivity or the increase in global savings over the period, which likely reduced demand for borrowing and increased the supply of savings, respectively.
Based on their economic projections and public statements, the FOMC believes R-star is roughly between 0.5 and 1 percent, which is basically unchanged from the pre-pandemic estimate. After adding the Federal Reserve’s long-standing 2 percent inflation target, we arrive at a nominal neutral rate of between 2.5 and 3 percent. Therefore, the current stance of monetary policy is just now entering restrictive territory based on the Fed’s estimates. Arguably, the ongoing period of high inflation has increased R-star, at least in the short-run, from the pre-pandemic level because high inflation disincentivizes savings. If this is the case, the economy may perform better than expected over the next few quarters. Although, it may also mean policymakers will need to increase rates even further than currently expected to slow inflation.
David Allen, CFA, CFP
Chief Investment Officer
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