The R-Star and the Fed’s Policy Debate


The fate of the market is intertwined with a concept called R-Star. The R-Star, also known as R*, represents the neutral rate of interest. It is a crucial factor that influences the Federal Reserve’s policy decisions in the long run.

At the upcoming Jackson Hole summit, estimates of the neutral rate are expected to dominate discussions among Fed officials and could even impact the stock and bond markets.

R-Star represents the real interest rate at which the demand for savings and investment reaches equilibrium within the economy. When the benchmark interest rate is at its neutral level, it neither stimulates nor restrains growth and inflation. In other words, monetary policy remains balanced.

According to the Fed’s latest economic projections from June, the median estimate for the longer-run federal-funds rate is 2.5%. By subtracting the central bank’s 2% inflation target, the estimated neutral rate stands at 0.5%. This has been the Fed’s median estimate since 2019.

One of the challenges with determining the neutral rate is that it cannot be precisely measured at any given moment. It is a theoretical concept that only becomes partially observable in hindsight.

Fed Chairman Jerome Powell admitted last year that there is no clear and precise understanding of what the neutral rate truly is and what real rates signify.

Nevertheless, despite this lack of clarity, the economy continues to display resilience. Over the past 18 months, interest rates have increased by 5.25 percentage points. This has reignited debates among economists and commentators about the actual level of the neutral rate. If the current fed-funds target range of 5.25% to 5.5% does not significantly slow down the economy, it suggests that the neutral rate may be higher than previously believed.

The Changing Landscape of Interest Rates

During the pandemic, a surplus of savings has been accumulated by individuals and businesses. Additionally, many have taken advantage of long-term borrowing at historically low interest rates. Surprisingly, this combination of factors has the potential to raise the neutral rate in the short term. As recent research suggests, the neutral rate could be around 1.5% to 2.0%.

This revelation challenges our previous assumptions about real interest rates and their impact on the economy. Higher rates may not have the expected dampening effect on growth and inflation. Tom Essaye, president of Sevens Report Research, explains that this new understanding doesn’t necessarily mean that the Federal Reserve will continue to raise rates. Instead, it suggests that rates will be kept “higher for longer” as they won’t hinder economic growth as initially predicted.

These shifting dynamics will be a focal point of discussion at this year’s Jackson Hole conference, with the theme being “Structural Shifts in the Global Economy.” Federal Reserve Chair Jerome Powell will deliver the keynote speech on Friday.

If there are any indications that Fed officials are contemplating an upward revision of the neutral rate estimate, it would signal a more hawkish stance. This would imply a need for an increase in the fed-funds rate in the near future or the need to maintain higher rates even as inflation trends lower.

Such expectations could drive bond yields even higher. Already in August, the 10-year Treasury note yield has risen by 0.38 percentage points to 4.34%, reaching its highest level since 2007. The equity market, especially growth stocks, would face headwinds if markets begin to price in a higher neutral rate.

Overall, the landscape of interest rates is undergoing a significant shift. It’s crucial for market participants to stay informed and adapt accordingly.

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