In the world of finance and economics, there’s a mysterious star that the Federal Reserve is relentlessly pursuing. This star, however, isn’t a celestial body that graces the night sky with its radiance. It’s an abstract concept known as R-star, or the “neutral interest rate.” Fed Chair Jerome Powell shed light on this elusive term, saying, “We only know it by its works.” But what exactly is R-star, and why is it so important to the Federal Reserve?
The origin of the term R-star can be traced back to 1898 when Swedish economist Knut Wicksell introduced it. He described it as “a certain rate of interest on loans which is neutral in respect to commodity prices and tends neither to raise nor to lower them.” In simpler terms, R-star is the Goldilocks interest rate, one that neither fuels inflation nor triggers a recession.
To define R-star more precisely, a model devised by a World Bank economist, New York Fed President John Williams, and a former top adviser to Powell characterizes it as “the real short-term interest rate expected to prevail when an economy is at full strength and inflation is stable.”
So, what does R-star mean in practical terms? It stems from economic models that analyze the demand for savings and investment in an economy. Both are influenced by inflation-adjusted interest rates, represented as the variable ‘r’ in these models. The interest rate that equates the demand for savings with the demand for investing is typically denoted as R*.
In theory, this perfect interest rate exists in the real world, and it plays a crucial role in helping the Federal Reserve achieve a soft landing – taming inflation without triggering a recession. However, in practice, finding this elusive R-star is a challenging task.
In the aftermath of the pandemic, when inflation surged unexpectedly and persisted longer than anticipated, the US central bank, like its global counterparts, found itself playing catch-up. To combat inflation, the Fed began raising interest rates. This move made borrowing money more expensive for both businesses and consumers, leading to reduced spending. When people spend less, businesses struggle to raise prices.
While the Fed kept interest rates unchanged at two of its policy meetings this year, Powell hinted that the central bank might not be finished with rate hikes just yet. He emphasized, “The fact that we decided to maintain the policy rate of this meeting doesn’t mean that we’ve decided that we have or have not, at this time, reached that stance of monetary policy that we’re seeking.”
Inflation continues to hover above the Fed’s 2% target. Simultaneously, if central bank officials persist in raising rates to curb inflation, they risk overshooting the mark. This is due to the lag between the Fed’s actions and their impact on the economy, which spans roughly a year. Hence, Powell stressed that the central bank is proceeding cautiously.
However, waiting too long to act could lead to higher-than-desirable inflation becoming ingrained in the economy, making it much harder to control. As Powell aptly pointed out, “you only know when you get there and by the way the economy reacts.”
In the quest for this economic North Star, the Fed continues to navigate a delicate balancing act, seeking that elusive R-star that will guide the economy to a soft landing.
