Fixed-Income Insights
Is “R-Star” Losing Its Luster as Guidance for U.S. Monetary Policy?
The shift in sentiment regarding “r-star” may reflect a new reluctance on the part of the U.S. Federal Reserve to rely on forecasts, as opposed to actual data, in the formation of monetary policy.
One of the key factors that has influenced the direction of U.S. monetary policy in recent years is the so-called “neutral” or “natural” rate of interest or, as it is often referred to by policy wonks, “r-star” (r*).
You won’t find r-star quoted on your computer screen. It cannot be observed directly. Instead, it is an estimated or “inferred” short-term rate generated by various models using inputs supposed to be reflective of long-term prospects for U.S. economic growth, global growth, and overall financial conditions.
Typically adjusted for inflation, r-star is assumed to represent the interest rate that would be consistent with the economy running at full strength (i.e., maintaining full employment with associated price stability)—in effect, a sort of theoretical fed funds rate at which the stance of the U.S. Federal Reserve’s (Fed) monetary policy is neither accommodative nor restrictive, hence “neutral.”
In terms of monetary policy, r-star matters because it has acted as a guidepost for the Fed—helping it to judge whether the interest rate it sets is stimulating or restraining the economy. Accordingly, in an inflationary environment, r-star is the point above which the Fed would want to set the fed funds rate if it wishes its policy to be restrictive, i.e. to slow a booming economy. In a recessionary environment, r-star is the point below which the Fed would want to set the fed funds rate if it wishes policy to be accommodative, i.e. to boost economic growth.
Economists use different models to estimate r-star. Widely cited estimates from models produced by Federal Reserve economists Kathryn Holston and Thomas Laubach and John Williams, currently president of the Fed Bank of New York, put r-star at about 0.8% in the United States, down from 3.6% in 1985 (see Chart 1). As Chart 2 illustrates, the trend is similar for other advanced economies.
Chart 1. The R-Star for the United States is Low by Historical Standards
LW Estimation (Model 2003) of r-star and trend growth, 1985-2020 (Model data as of November 11, 2019)
Source: Laubach and Williams (LW2003 Model). Note: Estimates of the natural rate of interest (r-star) are plotted along with those for the trend growth rate of the U.S. economy, a source of change driving r-star.
Chart 2. The R-Star for Advanced Economies in General is Also Historically Low
HLW estimation (Model 2017) of R-star and trend growth, 1985-2020 (Model data as of November 11, 2019)
Sources: Holston, Laubach, and Williams (HLW Model 2017) and the Organization for Economic Cooperation and Development (OECD). Note: Estimates are GDP-weighted averages across the United States, Canada, the Eurozone, and the United Kingdom. The Model uses OECD estimates of GDP at purchasing power parity. (Purchasing power parity is a theory that measures prices at different locations using a common good or goods to contrast the real purchasing power between different currencies.) For dates prior to 1995, Eurozone weights are the summed weights of the 11 original Eurozone countries.
An r-star of 0.8% is low by historical standards and is part of a pattern that has seen the neutral rate of interest declining for over three decades. With low levels of U.S. inflation as well, the Fed could soon be up against what is known as the “effective lower bound” as rates slip below zero into negative territory. When interest rates fall to zero or below, and the economy is still underperforming, the Fed loses its ability to lower rates further to stimulate the economy.
The Fed’s response to past recessions has been to cut nominal interest rates by 5.3 percentage points on average, according to the Hutchins Center. If inflation is 2% (the Fed’s target for inflation) and the r-star is 0.8%, the normal level of nominal interest rates (i.e. without adjusting for inflation) would hover around 2.8%. In that case, the Fed won’t be able to cut rates by anywhere near 5 percentage points in a recession before hitting zero.
Moreover, since r-star is a “real” rate, i.e. adjusted for inflation, it would be more difficult to engage in an expansionary monetary policy when both r-star and inflation are low.
Williams has always believed that r-star “matters a great deal because it anchors where short-term interest rates will tend to be in the future. In a world of low r-star, policymakers, banks, businesses, and households all need to plan for lower interest rates than they’ve experienced in decades past,” he has said.1
But more recently, even Williams is downplaying its use as a tool to guide monetary policy. In a 2018 speech, Williams emphasized that while r-star is a good benchmark as a general concept, it is less useful as a precise estimate of what rates should be in the near term. “R-star is just one factor affecting our decisions, alongside economic and labor market indicators, wage and price inflation, global developments, financial conditions, the risks to the outlook,” he said in remarks at a Columbia University forum in September 2018.2
Kevin Warsh, a former Fed governor during and after the 2008-09 financial crisis, warned that r-star itself may be endogenous to economic policy. “Policy makers’ own choices about taxes, spending, regulation, and trade alter the economy’s potential growth in lagged and imprecise ways and thus affect any meaningful estimate of r-star.”3
While the Fed sets short-term interest rates such as the fed funds rate, r-star is the result of longer-term economic factors beyond the influence of central banks and monetary policy. These factors may include changes in demographics, productivity, global savings, and the appetite for risk.
Current Fed Chairman Jay Powell has also downplayed the use of r-star. Because it can’t be directly observed, he reasoned, estimates are uncertain and monetary policy has to be cautious about using it as a benchmark.
The shift in sentiment regarding r-star may also reflect a new reluctance on the part of the Fed to rely on forecasts, as opposed to actual data, in the formation of monetary policy. This may be why the Federal Open Market Committee changed emphasis recently to a regime in which it will wait for reported inflation to rise, as opposed to forecasts of rising inflation, before actually raising rates.
Finally, as Warsh has observed, monetary policy is not just about rates. It includes unconventional monetary tools such as quantitative easing and forward guidance. The year 2020 also may see a change in the Fed’s monetary framework, including revised inflation targeting practices. In any case, with rates approaching the effective lower bound, the Fed will have to be creative in conducting monetary policy when the next recession arrives.
1John C. Williams, The Future Fortunes of R-star: Are They Really Rising?, speech to the Economic Club of Minnesota, May 15, 2018.
2 John C. Williams, ‘Normal’ Monetary Policy in Words and Deeds, speech to the Columbia University, School of International and Public Affairs, September 28, 2018.
3Kevin Warsh, The Fault Lies in R-Star and in Ourselves, “The Wall Street Journal”, Opinion, September 25, 2018.
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