The market’s fate is written in the stars—the R-Star, that is. Where the neutral rate of interest lies is the latest debate with implications for Federal Reserve policy over the long haul.
Estimates of the neutral rate could be all the buzz at the Fed’s annual Jackson Hole summit this week and could even get a reaction from the stock and bond markets.
R-Star, often stylized as R*, is the real interest rate where demand for savings and investment in the economy is at an equilibrium. A benchmark interest rate at neutral neither fuels nor restricts growth and inflation. Put another way, monetary policy is neither tight nor loose.
The Fed’s latest economic projections, from June, put the median estimate of the longer-run federal-funds rate at 2.5%. Subtracting the central bank’s 2% inflation target yields an estimated neutral rate of 0.5%, which is the Fed’s median estimate since 2019.
A key sticking point with the neutral rate: It isn’t measurable in the moment. It’s theoretical, and only somewhat observable in hindsight.
“I don’t see us as having a really clear and precise understanding of what the neutral rate is and what real rates are,” Fed Chairman Jerome Powell said late last year.
Nonetheless, the economy’s enduring strength—interest rates have gone up 5.25 percentage points in the past 18 months—has economists and commentators once again debating where the neutral rate actually is. If the current fed-funds target range of 5.25% to 5.5% isn’t meaningfully slowing the economy, it could be because the neutral rate is higher than thought.
A glut of savings built up during the pandemic together with businesses and homeowners locked into long-term borrowing at low interest rates could have the effect of raising the neutral rate—at least in the short run. That suggests the fed-funds rate would need to be higher to slow growth. The neutral rate may be more like 1.5% or 2.0%, as recent research suggests.
“If that’s the case, then real interest rates aren’t as restrictive as we thought they were, and as a result rate hikes won’t slow the economy nor blunt inflation as much as the Fed would expect,” wrote Tom Essaye, president of Sevens Report Research, on Tuesday. “The net result isn’t so much that the Fed will keep raising rates, but instead that the Fed will keep rates ‘higher for longer,’ because they aren’t as much of a headwind on growth as was previously expected.”
The theme of this year’s Jackson Hole conference, which runs Thursday to Saturday, is “Structural Shifts in the Global Economy.” The postpandemic neutral rate certainly fits as subject matter for the movers and shakers to talk about. Powell gives the keynote speech on Friday.
Any indication that Fed officials may be thinking about a higher estimate of the neutral rate would send a hawkish message. The suggestion would be that the fed-funds rate needs to rise in the near term, or remain higher for longer even as inflation trends lower.
Bond yields could rise further—the 10-year Treasury note yield is already up 0.38 percentage point in August, to 4.34%, its highest yield since 2007—should markets move to price in a higher neutral rate. That would be a headwind for the equity market and growth stocks in particular.
Write to Nicholas Jasinski at [email protected]
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