Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Watching the Neutral Rate Again
Transcript
- Lucas: So the Federal Reserve released their June Summary of Economic Projections a few weeks ago, and buried in the dot plot is a number that doesn't get nearly enough attention — the median longer-run federal funds rate estimate. Luna: That's the neutral rate, right? The rate that neither stimulates nor restrains the economy? Lucas: Exactly. Economists call it R-star — the real neutral rate of interest. And the median estimate in the June 2026 SEP ticked up to 3.1 percent. Back in 2019, it was 2.5 percent. That is a meaningful shift in what the Fed thinks is normal. Lucas: And it matters because if the neutral rate is higher, then a given policy rate is less restrictive. If the Fed funds rate is at 4.5 percent and R-star is 3.1 percent, the real stance is only about 140 basis points tight. If R-star were 2.5, that same 4.5 percent rate would be 200 basis points tight. Luna: So the same nominal rate can be hawkish or dovish depending on where R-star sits. That's a huge moving target for policymakers. Lucas: It is. And R-star is unobservable. You can't look it up on Bloomberg terminal — it's estimated from models. The New York Fed publishes a few measures, the Laubach-Williams model being the most famous. That model currently puts the real neutral rate at around 1.2 percent, which is notably below the SEP's real neutral estimate of roughly 1.1 percent after subtracting 2 percent inflation. Luna: So the Fed's own staff model says one thing, but the SEP dot says another. Which one should we trust? Lucas: That's the million-dollar question. The Laubach-Williams model has been pretty stable — it only moved up about 30 basis points from 2020 to now. But the SEP dots reflect committee judgment, and that judgment has shifted more. Some of that is because the economy has been more resilient to rate hikes than models predicted. Lucas: Quick honest thing — we can keep doing deep dives like this because a handful of listeners chip in monthly at buy me a coffee dot com slash fexingo. That's literally what funds making this many of these shows. If walking through the economy with us has made something click, that's the place. Luna: Yeah, it's a small group, and it makes a real difference. Keeps us ad-free and focused on the substance. Lucas: So back to R-star — one reason it might be rising is the fiscal story. The US is running large structural deficits, around 6 percent of GDP, even in a strong economy. That persistent borrowing absorbs private savings and pushes up the real rate that clears the market. Luna: Right, the crowding-out argument. More government debt means higher equilibrium rates. Lucas: Exactly. Pre-pandemic, the secular stagnation camp, like Larry Summers, argued that R-star was very low because of aging demographics, low productivity growth, and a glut of savings. But the post covid fiscal expansion, plus ai driven investment demand, may have shifted the landscape. Luna: So we could be in a new regime where neutral rates are structurally higher. That would change the entire playbook for how restrictive policy is. Lucas: It would. And it has implications for asset prices too. If R-star is higher, the discount rate on future cash flows is higher, which weighs on equity valuations, especially for long-duration growth stocks. In 2026, we've seen rotation into value and commodities partly for that reason. Luna: But the models have been wrong before. The Laubach-Williams model, for instance, was revised down repeatedly after the 2008 crisis. What if they're wrong again, but in the other direction? Lucas: That's the key risk. The confidence intervals around R-star estimates are enormous — like plus or minus two percentage points. So when the Fed says the neutral rate is 3.1 percent, the true value could be anywhere from 1.5 to 4.5. That's a wide range for setting policy. Luna: And if you're a policymaker, you don't want to overreact to a model that might be shifting. You want to see actual inflation and growth data to confirm the neutral rate has moved. Lucas: Right. Chair Powell has said before that the Fed is 'flying on instruments' when it comes to R-star. They look at a range of indicators — term premiums, breakeven inflation rates, survey expectations, and the actual response of the economy to rate changes. Lucas: One concrete data point: the ten-year Treasury yield minus the two-year has stayed inverted for a record duration in 2024 and 2025, but it has normalized in early 2026. Some interpret that as the market pricing in a higher neutral rate. Luna: But the inversion could also have been about term premium compression from quantitative tightening. It's not a clean read. Lucas: No, it's not. That's why central banks spend so much time on internal models and staff research. The New York Fed's R-star estimate is just one input, but it feeds into the broader assessment. Luna: So for the average listener, why should they care about R-star? It seems pretty abstract. Lucas: Because it determines how tight monetary policy really is. If the Fed thinks R-star is 2.5 but it's actually 3.5, they might keep rates too high, slow the economy more than needed, and cause a recession. On the flip side, if they underestimate it, they might cut too early and reignite inflation. Luna: So getting R-star wrong can lead to policy errors with real consequences for jobs and prices. That's why it's such a hot topic in central banking circles. Lucas: And it's not just the Fed. The ECB, Bank of England, Bank of Japan — all of them have their own R-star estimates, and they're all grappling with the same question: has the neutral rate risen globally? Luna: The IMF's latest World Economic Outlook had a chapter on this. They found that neutral rates in advanced economies have likely increased by 50 to 100 basis points since 2020, driven by higher fiscal deficits and investment demand. Lucas: That's a big deal. If neutral rates are structurally higher, then the era of zero interest rates and quantitative easing may be behind us. Not permanently, but for this cycle at least. Luna: So what's the one thing you would tell listeners to watch for to gauge where R-star is heading? Lucas: Watch the Treasury term premium. A rising term premium, all else equal, suggests investors demand more compensation for holding long-term debt, which is consistent with a higher neutral rate. Also, watch the Fed's next SEP in September — if the median dot moves up again, that confirms the shift. Luna: And if the data starts to soften, the Fed might cut rates even if R-star is higher, because the actual neutral is still below the current policy rate. It's all relative. Lucas: Exactly. R-star is the anchor, but the crew still has to navigate the currents. Thanks for listening — we'll be back next week with another angle on the economy you won't hear everywhere else.