Revisiting R-Star — Evening Brief – 07.22.24
It is widely anticipated that the Federal Reserve will begin loosening monetary policy at the September 18 FOMC meeting. However, the current discussion centers on the extent to which the central bank will reduce its policy rate once the easing begins. The extent to which the neutral rate has increased, if at all, in recent years will play a crucial role in determining the answer.
The neutral rate (the natural rate or R-star) refers to the rate at which the economy can grow over time without causing an increase in inflation. However, the true neutral rate cannot be directly observed, hence economists can only approximate it using models.
According to a study conducted by the New York Federal Reserve, the neutral rate has decreased and currently stands at approximately 1.2% as of the first quarter of this year. While the current percentage is higher than it was 10 years ago, it is still lower than the approximately 3% rate that was common in the 1980s and 1990s.
However, accurately determining the neutral rate is challenging and there exist extensive discussions on the most effective methodology. Unsurprisingly, estimates differ, sometimes significantly. Recent surveys suggest that several economists believe the neutral rate has risen. The Bank of International Settlements recent noted that “the recent reemergence of upside inflation risks inducing a tighter monetary policy stance going forward may have pushed at least perceptions of r* higher.”
In May, Reuters reported on a survey conducted by the New York Fed among large banks prior to the March meeting. The study revealed that dealers estimated a longer-term interest rate of nearly 3%, which was an increase from the previous year’s estimate of 2.5%.
TD Securities analysts informed clients in a recent note that they believe the long-run nominal neutral rate is probably 50 basis points higher at 2.75% to 3.00%. However, they also acknowledge the possibility of a little higher level, potentially around 3.50%. According to a study from the San Francisco Fed, their internal estimate for the longer-run interest rate is 2.75%.
The outcome of this argument holds significant consequences for the future direction of monetary policy. If the neutral rate has risen, it is likely to impose constraints on the extent to which the Fed can reduce interest rates. While there are other factors involved in determining the neutral rate, one approximate method for assessing the directional tilt is by considering the real (inflation-adjusted) interest rates. In recent years, there has been a significant increase.
“If they’re going to do two [cuts] this year, they’re effectively going to be at neutral by the end of the year,” said Jim Bianco of Bianco Research. “Given the strength of the economy, I don’t think it’s warranted.”