Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use the Natural Rate of Interest
Transcript
- Lucas: Central bankers have a concept they call the 'natural rate of interest' — often shortened to R-star, with an asterisk. It's the theoretical interest rate that keeps the economy humming at full employment with stable inflation, without adding any extra stimulus or drag. Luna: So it's like the Goldilocks rate — not too hot, not too cold. But how do you actually measure something that you can't directly observe? Lucas: That's the trillion-dollar question. R-star is estimated using economic models that look at things like productivity growth, demographics, savings behavior, and global capital flows. The most famous model is the Laubach-Williams framework from the San Francisco Fed, which has been tracking R-star for the US since the 1960s. Luna: Right, and those estimates show a clear downward trend. In the 1980s, the natural rate was around 4 or 5 percent. By the 2010s, it had dropped close to zero, sometimes even negative in real terms. Lucas: Exactly. And that decline matters enormously because it tells central banks how much room they have to cut rates in a recession. If the natural rate is low, the policy rate doesn't have to fall as far to be stimulative — but it also means the old normal of 5 percent rates is probably gone. Luna: So when the Fed raised rates rapidly in 2022 and 2023, they were trying to figure out if they were above R-star or still below it. That's basically the whole debate about how restrictive policy really is. Lucas: Precisely. As of mid-2026, most estimates put the real natural rate for the US somewhere between 0.5 and 1.5 percent. The nominal fed funds rate, even after some cuts, is still above 3 percent — so policy is clearly restrictive. But the exact degree depends on which R-star estimate you trust. Luna: And trust isn't easy. These models have big confidence intervals. The Laubach-Williams estimate, for example, comes with a plus or minus of about 1.5 percentage points. That's a huge range when you're trying to be precise. Lucas: Right. And there's a deeper issue: R-star itself isn't fixed. It changes over time with the economy. The pandemic, for instance, may have shifted it. Some economists argue that the massive fiscal spending and supply-chain disruptions temporarily raised the natural rate, while others think the long-term forces — aging populations, slower productivity — continue to push it down. Luna: The Bank of Japan has been dealing with this for decades. Japan's natural rate is thought to be close to zero or even negative, which is why they've had such a hard time normalizing policy. Even a small hike can feel very restrictive. Lucas: That's a great example. In fact, the Bank of Japan publishes its own R-star estimates, and they've been below zero since the late 1990s. That explains why they've kept rates negative or near zero for so long — any positive rate would be above the natural rate and risk tipping the economy back into deflation. Luna: So if R-star is so uncertain, why do central banks rely on it at all? Why not just look at inflation and employment directly? Lucas: Because those are backward-looking. R-star is a forward-looking concept — it tells you whether current policy is too tight or too loose given the economy's long-run potential. Without it, you're flying blind. The Fed's dot plot, for instance, is essentially each member's guess about where the natural rate lies. Luna: But critics say it's a dangerous concept. Former Fed Chair Alan Greenspan once called it 'a will-o'-the-wisp' — something that's impossible to pin down and could lead to policy mistakes. Lucas: And there have been mistakes. In the 2000s, the Fed kept rates low for a long time, partly because models suggested R-star had fallen. That may have contributed to the housing bubble. On the flip side, if you assume R-star is higher than it really is, you might tighten too much and cause a recession. Luna: So it's a useful framework but not a rule. The European Central Bank has been especially cautious about using R-star as a guide, partly because the euro area is so diverse — one natural rate for Germany might not fit Greece. Lucas: That's a key point. The ECB uses multiple models and doesn't rely on any single estimate. They also look at market-based measures, like the forward real rate derived from inflation-linked bonds, to cross-check their R-star estimates. Luna: Market-implied R-star — that's the rate that financial markets expect the neutral rate to be, based on bond yields and inflation expectations. It's been drifting lower in the US and Europe for years. Lucas: And it's been particularly interesting to watch in 2026. After the post-pandemic inflation spike, many assumed the natural rate would rise. But recent data from the New York Fed's model shows R-star has actually edged down slightly over the past year. That suggests the underlying structural forces — aging demographics and slower productivity growth — are still dominant. Luna: Meaning central banks might have less room to cut in the next downturn than they think. If R-star is lower, the zero lower bound becomes a bigger constraint. Lucas: Exactly. That's why some economists argue that central banks should raise their inflation targets — from 2 percent to 3 or 4 percent — to create more buffer before hitting the zero lower bound. But that's a whole other debate. Luna: Before we get too deep into that, I want to touch on something practical. If you're an investor or someone trying to make sense of central bank communications, how do you track R-star? Lucas: A few places. The San Francisco Fed updates its Laubach-Williams estimate quarterly. The New York Fed has its own model, and the Cleveland Fed publishes a measure based on Treasury yields. There's also the Atlanta Fed's 'shadow rate' concept, which tries to capture the stance of policy when rates are near zero. Luna: But none of these are perfect. They all rely on historical relationships that might break down. And as we've seen, the models can disagree significantly. Lucas: That's why the Fed's leadership often talks about a 'range of plausible estimates' rather than a single number. Chair Powell, for instance, has said that R-star is one of the most uncertain concepts in economics — but also one of the most important. Luna: Speaking of important but uncertain — this show itself is only possible because of a small group of listeners who support it. It's a similar kind of thing: we don't have a big marketing budget or ads. It's just people who find value and chip in. Lucas: Yeah, it's pretty straightforward. If walking through the economy with us has made something click, you can help keep this ad-free at buy me a coffee dot com slash fexingo. That's buymeacoffee.com/fexingo. No pressure, just a way for those who find it useful to keep it going. Luna: And it honestly makes a difference. Every bit helps us keep digging into topics like R-star, output gaps, and all the weird tools central banks have in their toolbox. Lucas: Anyway — back to the natural rate. One last thing I think is worth highlighting: the concept isn't just academic. It directly affects your mortgage rate, your car loan, and your job prospects. When central banks misjudge R-star, they either overheat the economy or choke off growth. Luna: So the next time you hear a Fed official talk about 'the neutral rate', you'll know they're wrestling with this invisible number that shapes everything. Lucas: And it's a reminder that even the most sophisticated central bank is making its best guess. Humility matters in monetary policy — and R-star is the ultimate reason why.