Neutral_real_interest_rate_r*

What Is Neutral Real Interest Rate (r*)?

The neutral real interest rate, often denoted as r* (pronounced "r-star"), is a theoretical interest rate that is consistent with an economy operating at its potential output with stable inflation. It represents the rate at which monetary policy is neither stimulative nor restrictive. This concept is central to macroeconomics and is a key guide for central banks, such as the Federal Reserve, when setting their policy rates. The neutral real interest rate is "real" because it is adjusted for inflation, reflecting the true cost of borrowing and the true return on savings.

History and Origin

The concept of a natural rate of interest can be traced back to Swedish economist Knut Wicksell in the late 19th and early 20th centuries, who described it as the interest rate that would maintain a stable price level and full employment. In modern usage, the neutral real interest rate, or r*, gained significant prominence following the Global Financial Crisis of 2007-2008, as central banks struggled with near-zero nominal interest rates. Economists recognized the need for a benchmark rate that was independent of short-term economic fluctuations.

Prominent estimates of r* are provided by Federal Reserve economists Kathryn Holston, Thomas Laubach, and John Williams (HLW model). Their work, initially published in 2017, provides widely cited estimates of the long-run neutral rate for various economies, including the United States and the Eurozone.¹⁷ The HLW model and similar approaches have become crucial for policymakers attempting to gauge the stance of monetary policy.

Key Takeaways

• The neutral real interest rate (r*) is a theoretical rate that supports an economy at its maximum sustainable economic growth and stable inflation.
• It is a "real" rate, meaning it is adjusted for inflation.
• Central banks use r* as an unobservable benchmark to determine whether their current policy is expansionary or contractionary.
• Estimates of r* have generally declined over recent decades due to factors like slowing productivity growth and changing demographics.
• Its unobservable nature and estimation challenges lead to significant uncertainty regarding its precise value.

Formula and Calculation

The neutral real interest rate (r*) is a theoretical construct and cannot be directly observed or measured with a simple formula. Instead, it is estimated using complex econometric models that analyze various macroeconomic data. One widely cited framework, the Holston-Laubach-Williams (HLW) model, attempts to estimate r* by considering trends in output, inflation, and observable market interest rates.

These models typically rely on the relationship between an economy's potential output, or "y-star," and the observed real interest rate. The objective is to find the real interest rate that would result in the output gap being zero, where the economy is operating at its capacity without generating inflationary or deflationary pressures. While specific mathematical equations underpin these models, they are highly intricate and involve statistical filtering techniques rather than a straightforward calculation that an individual can perform.

Interpreting the Neutral Real Interest Rate (r*)

Interpreting the neutral real interest rate is critical for understanding the stance of monetary policy. If the actual real federal funds rate (or a similar short-term policy rate) is above the estimated r*, monetary policy is considered restrictive or "tight." This implies that borrowing costs are higher than what's necessary to maintain full economic potential and stable prices, potentially leading to slower economic activity and reduced inflation. Conversely, if the actual real rate is below r*, monetary policy is expansionary or "loose," encouraging borrowing, investment, and aggregate demand, which could fuel inflation.¹⁶

Central banks constantly monitor and adjust their policy rates relative to their assessment of r* to achieve their dual mandate of maximum sustainable full employment and price stability. However, because r* itself is unobservable and subject to revision, its interpretation involves a degree of uncertainty.¹⁵

Hypothetical Example

Consider a hypothetical central bank in the country of Econland. For years, the central bank had estimated Econland's neutral real interest rate (r*) to be around 1.5%. This meant that a real policy rate of 1.5% was thought to be consistent with stable inflation and the economy operating at its potential.

In a particular year, the Econland central bank observes that the economy is showing signs of overheating: inflation is rising above its target, and the labor market is extremely tight. The current real policy rate is 1.0%. Based on their understanding of r*, the central bank believes that their current policy is too accommodative (1.0% is below the estimated 1.5% r*). To cool down the economy and bring inflation back to target, the central bank decides to raise its nominal policy rate, effectively increasing the real policy rate towards or even above the estimated 1.5% r*. This move aims to curb aggregate supply and demand pressures.

Practical Applications

The neutral real interest rate plays a pivotal role in several areas of finance and economics:

• Monetary Policy Setting: Central banks like the Federal Reserve use estimates of r* as a crucial benchmark to set their nominal policy rates. By comparing the current real policy rate to r*, they can determine if their stance is accommodative, restrictive, or neutral, guiding their decisions on interest rate adjustments.¹⁴ For example, if the real federal funds rate is significantly below r*, the central bank might consider raising rates to prevent overheating.
• Economic Forecasting: Economists and financial analysts use r* estimates to forecast future interest rate trends and economic conditions. A declining r* can suggest a "lower for longer" interest rate environment, impacting long-term bond yields and investment returns.
• Fiscal Policy Coordination: Understanding r* can inform fiscal policy decisions. If r* is very low, the effectiveness of monetary policy in stimulating the economy during a downturn might be limited, placing more emphasis on fiscal measures.
• Investment Strategy: Investors, particularly those focused on long-term portfolio planning and asset allocation, consider prevailing estimates of r*. A lower r* environment can imply lower long-term equilibrium real returns across various asset classes, influencing expected returns for equities, bonds, and other investments. This can affect considerations like the steepness of the yield curve.
• International Comparisons: The neutral real interest rate can also be compared across countries, providing insights into global capital flows and relative economic health. Emerging markets, for instance, often have higher neutral rates than advanced economies, reflecting different stages of development and investment opportunities.¹³

Limitations and Criticisms

Despite its importance, the neutral real interest rate is subject to several limitations and criticisms:

• Unobservability: The primary challenge is that r* cannot be directly observed; it must be estimated. These estimates are model-dependent and can vary significantly across different methodologies, leading to a high degree of uncertainty.¹² This makes it difficult for policymakers to definitively know the true value of r* at any given time.¹¹
• Real-time Estimation Difficulties: Real-time estimates of r* are particularly challenging and are frequently revised as new data become available. What was thought to be the neutral rate a few years ago might be significantly different today, making it a "moving target" for policy.¹⁰
• Theoretical Assumptions: The models used to estimate r* rely on various theoretical assumptions about how the economy functions, such as the relationship between potential output, inflation, and real interest rates. If these assumptions are flawed or if structural changes occur in the economy, the accuracy of the estimates can be compromised.⁹
• Debate on Drivers: While factors like demographics, productivity growth, and demand for safe assets are widely accepted as long-term drivers of r*, there is ongoing debate about their precise impact and whether recent increases are temporary or persistent.⁸
• Policy Neutrality Debate: Some economists question whether monetary policy itself can influence the long-run natural rate of interest, challenging the assumption that r* is independent of policy decisions.⁷

Neutral Real Interest Rate (r*) vs. Nominal Interest Rate

The neutral real interest rate (r*) and the nominal interest rate are distinct yet related concepts in finance.

The key difference lies in the adjustment for inflation. The nominal interest rate is what you actually see quoted—for example, the rate on a mortgage or a savings account. It includes an expectation of inflation. The neutral real interest rate, however, strips out inflation to reflect the underlying "real" cost of capital or return on savings in an economy operating at its full potential. Central banks aim to manipulate the nominal interest rate to achieve a real policy rate that aligns with their assessment of the unobservable r* and economic goals.

FAQs

What causes the neutral real interest rate to change?

The neutral real interest rate is influenced by fundamental, long-term structural factors in the economy. Key drivers include changes in demographics (e.g., an aging population that saves more), shifts in productivity growth (slower growth may reduce investment demand), global supply and demand for capital, and risk aversion. These factors evolve slowly, leading to gradual changes in r* over decades.

⁶### Is the neutral real interest rate the same as the natural rate of interest?
Historically, the terms "neutral real interest rate" and "natural rate of interest" have been used interchangeably by many economists. Both refer to a real interest rate that is consistent with the economy operating at its full potential without generating inflationary or deflationary pressures. While some academic distinctions may exist in certain models, for practical purposes in monetary policy discussions, they often refer to the same concept.

⁴, ⁵### Why is r* important for central banks?
The neutral real interest rate is crucial for central banks because it serves as a "guidepost" for setting their policy rates. By comparing the prevailing real policy rate to their estimate of r*, central banks can determine if their monetary policy is providing too much stimulus (real rate < r*), too little stimulus (real rate > r*), or is appropriately balanced (real rate ≈ r*). This helps them steer the economy towards their objectives of price stability and maximum sustainable employment.

##³# Can the neutral real interest rate be negative?
Yes, the neutral real interest rate can be negative. This implies that even if the economy is operating at its full potential with stable inflation, the equilibrium real borrowing cost would be below zero. A negative r* suggests a persistent excess of global savings relative to productive investment opportunities, which has been a concern for many advanced economies in recent decades.

##²# How does a low neutral real interest rate affect monetary policy?
A persistently low neutral real interest rate limits the room for central banks to cut nominal interest rates during economic downturns before hitting the zero lower bound. This can reduce the effectiveness of conventional monetary policy tools in stimulating the economy during a recession, potentially requiring central banks to rely more on unconventional measures like quantitative easing or forward guidance.¹