Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / The Fed's New Focus on the Neutral Rate
Transcript
- Lucas: So the effective fed funds rate is sitting at 3.63 percent as of May, and inflation is running at 4.2 percent on the headline CPI. That means the real policy rate is negative. Luna: Negative real rates, positive inflation, and the economy is still growing. That's a pretty unusual combination for this late in a tightening cycle. Lucas: Exactly. And it explains why the Fed's attention has shifted to something that used to be purely academic: the neutral rate of interest, also known as R-star. That's the rate that neither stimulates nor restricts the economy. Luna: I've seen estimates all over the map. The New York Fed's measure, the one they call HLW, has been creeping up. Lucas: Yeah, their latest reading from the first quarter put R-star at around 1.2 percent in real terms. That's up from basically zero a decade ago. And some economists think it could be even higher now, given the structural shifts we've seen. Luna: What kind of shifts? I mean, the pandemic is over, but the economy still looks different. Lucas: Right. You've got massive fiscal deficits, which increase the demand for savings. You've got the energy transition requiring huge capital investment. And you've got deglobalization — reshoring, supply chain redundancy — all of which raises the marginal product of capital. All of those push R-star higher. Luna: So if R-star is higher, then the Fed's current policy rate is even less restrictive than it looks. That would mean they need to keep hiking, or at least hold for longer. Lucas: That's the key takeaway. The ten-year breakeven inflation rate is at 2.31 percent, well above the Fed's 2 percent target. And core PCE is running at 2.3 percent annualized. The Fed is not at the finish line. Luna: And then you have the ECB hiking for the first time since 2023, partly because of energy costs from the Iran conflict. That's a global tightening impulse. Lucas: It reinforces the message: central banks everywhere are still fighting inflation. The Fed's dot plot from the last SEP showed a median terminal rate of 3.75 to 4 percent. But if R-star is higher, that terminal rate might not be high enough. Luna: Let's step back for a second. A lot of our listeners are trying to make sense of this for their own finances. If the Fed keeps rates higher for longer, that affects mortgages, car loans, credit cards, everything. Lucas: Absolutely. And that's actually a good point. If you're finding these connections useful, if walking through the economy with us has made something click, there's a simple way to keep this show ad-free and independent. You can support us at buy me a coffee dot com slash fexingo. Luna: Yeah, it's a small gesture that makes a big difference. No pressure, but if the show adds value, that's where you can help. Lucas: Back to R-star. The challenge is we can't observe it directly. It's estimated from models that use data like real GDP growth, demographics, and productivity. And those estimates come with a lot of uncertainty. Luna: Especially now, when the economy is still adjusting from pandemic-era distortions. Lucas: Right. Some Fed officials, like Christopher Waller, have argued that we should be humble about our ability to measure R-star in real time. That means relying more on the data — watching how the economy responds to current rates. Luna: So if the economy is still growing, hiring is still strong, and inflation isn't coming down fast enough, that's a signal that rates aren't yet restrictive. Lucas: Exactly. The small-cap index, the Russell 2000, is up over 3 percent in the last five days. That's not the behavior of an economy being choked by tight policy. Luna: And the ten-year yield has actually fallen about 6 basis points in the last week, to 4.49 percent. The bond market is perhaps not as worried about overheating. Lucas: Or maybe it's pricing in a softer landing. But the Fed can't afford to assume that. They've been burned before by declaring victory too early. Luna: The 1970s playbook. Arthur Burns kept rates too low for too long. Lucas: Exactly. So the current FOMC is more likely to err on the side of tightness. And if R-star is indeed higher, that means the neutral nominal rate could be 3.5 percent or more. With the fed funds rate at 3.63, they're barely there. Luna: Which means they have to keep rates at this level or hike further, even if inflation moderates a bit. Lucas: Precisely. The next CPI print and the next jobs report will be critical. But the deeper debate is structural: Is the economy's potential growth rate higher? Is the neutral rate permanently higher? Those answers will shape policy for years. Luna: And it's not just a US question. The ECB is dealing with the same uncertainty. They just hiked, and they're watching their own R-star estimates. Lucas: Right. So this is the central macroeconomic puzzle of 2026. And it doesn't have an easy answer. Luna: One thing we can say: the days of ultra-low rates are probably behind us. Lucas: That seems likely. The neutral rate is probably higher, and the Fed will have to adjust their thinking — and their forward guidance — accordingly.