Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Watching the Neutral Rate
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- Lucas: So there's this number that drives basically every interest rate decision the Federal Reserve makes, and nobody actually knows what it is. Luna: This sounds like one of those central-bank mysteries. Are we talking about R-star? Lucas: Exactly. R-star — the neutral rate of interest. In theory, it's the real short-term interest rate consistent with the economy operating at full employment and stable inflation. When the Fed sets its policy rate above R-star, policy is restrictive. Below it, policy is accommodative. The problem is, you can't observe it directly. It has to be estimated. Luna: And those estimates have been all over the place lately. I've seen papers suggesting R-star has risen maybe a full percentage point since 2020. Lucas: That's the big debate right now. Pre-pandemic, the consensus estimate for the US was somewhere around 0.5 percent in real terms — that's after inflation. Add two percent inflation, and you get a nominal neutral rate around 2.5 percent. But a lot of economists now think it could be 1.5 percent real or higher. If that's true, the current fed funds rate — which is around 5.25 percent — might not be as restrictive as everyone assumes. Luna: So the Fed could be tightening less than they think. That would explain why the economy has been so resilient. Lucas: Precisely. And this isn't just academic. The FOMC's own projections include a longer-run fed funds rate — essentially their estimate of nominal R-star — and they've been quietly revising it up. In 2019, the median dot was 2.5 percent. In the latest SEP, it's 3.0 percent. That's a big shift. Luna: But how do you even estimate something you can't see? Like, where does the number come from? Lucas: The most famous model is the Laubach-Williams model, developed by John Williams — who's now president of the New York Fed — and his co-author Thomas Laubach. It uses a statistical filter that extracts R-star from data on GDP growth, inflation, and the real interest rate. The idea is that over time, the real rate tends to gravitate toward the economy's potential growth rate. But the model has huge error bands. Luna: Huge as in plus or minus two percent? I remember reading that the confidence interval is basically the entire range of plausible policy rates. Lucas: That's exactly right. The San Francisco Fed publishes the model estimates, and the 90 percent confidence interval for current R-star is something like negative one percent to positive three percent. So when a policymaker says 'we're at neutral' or 'we're restrictive,' they're making a judgment call with a ton of uncertainty. Luna: And that uncertainty has real consequences. If the Fed thinks R-star is low, they might cut rates too early and reignite inflation. If they think it's high, they might keep rates too high and choke off growth unnecessarily. Lucas: Right. And this is especially relevant right now — June 2026 — because we've just come through a period where inflation fell from 9 percent to around 2.5 percent, but growth has stayed surprisingly solid. The natural question is: how much of that is due to a higher neutral rate? If R-star has risen, then maybe the economy can tolerate higher rates than we thought. Luna: What's driving it up? I've heard arguments about fiscal deficits, AI investment, reshoring, immigration — all sorts of factors. Lucas: All of the above. One theory is that large fiscal deficits increase the supply of government debt, which pushes up the real rate needed to clear the market for loanable funds. Another is that the productivity boost from AI and automation is raising potential growth, which mechanically lifts R-star. And then there's demographic stuff — if immigration boosts labor supply, that can also push up the neutral rate. Luna: It's funny — for years, the narrative was that R-star was falling because of aging populations and slow productivity. Now it might be rising again. Lucas: Exactly. The pre-2010 consensus was that R-star was maybe 2 percent real. Then after the financial crisis, it started drifting down — low growth, low inflation, quantitative easing — and by 2015, estimates were below 1 percent. The term 'secular stagnation' became popular. Now we're in maybe the opposite regime. Luna: But how do central banks actually use this in practice? The Fed doesn't set rates based on a model output. Lucas: No, but it informs their reaction function. When a Fed official says 'policy is restrictive,' they're implicitly comparing the current rate to their estimate of R-star. And when the dots shift, it's often because their view of the neutral rate has changed. Chair Powell has explicitly said that the uncertainty around R-star is one reason the Fed is moving cautiously now — they don't want to oversteer. Luna: And it's not just the Fed. The ECB has its own estimates, the Bank of Japan too. But the debate is hottest in the US because the data is most conflicting. Lucas: Right. The ECB's estimated R-star for the euro area is still very low — maybe zero or even negative in real terms. The BOJ is likely still below zero. But the US seems to be pulling away. That divergence has implications for exchange rates and capital flows. Luna: So if US R-star is higher, the Fed might keep rates higher for longer, which strengthens the dollar, which then tightens financial conditions globally. Lucas: That's the transmission. And it's why economists are spending so much time trying to pin down this one unobservable number. There's a famous line attributed to John Williams: 'R-star is a concept, not a number.' It's a framework for thinking about where rates should be, not a precise target. Luna: But markets love to pretend it's a number. Every time the Fed releases the SEP, traders immediately do the math: if the dots imply a terminal rate of X and the neutral is Y, then how many cuts do we get? Lucas: And that's where the danger is. Because if you get R-star wrong, your entire policy path is off. Remember 2021? The Fed thought the neutral rate was so low that they kept rates near zero while inflation was already building. In hindsight, that was a mistake. One reason was that they underestimated how much R-star might have risen due to fiscal stimulus. Luna: So what's the takeaway for someone listening? Like, how should an investor or a business owner think about R-star? Lucas: I think the most practical takeaway is humility. Anyone who tells you they know exactly where rates are headed is either overconfident or ignoring the uncertainty. R-star is a reminder that central banking is as much art as science. The best you can do is watch the data, watch the Fed's reaction function, and understand that the neutral rate is moving — probably higher than before — but we won't know for years. Luna: It reminds me a bit of the concept of potential GDP — also unobservable, but central banks rely on it constantly. You're making decisions based on something that might not exist. Lucas: Exactly. And it's worth noting that the Laubach-Williams model itself gets updated every quarter. The estimates are constantly revised as new data comes in. So what we think R-star is today might look very different a year from now. Luna: That level of uncertainty — it's almost humbling. And it's one reason we try to explain these concepts without pretending we have all the answers. Speaking of which, if walking through the economy with us has made something click, there's a way to support that clarity. Lucas: Yeah, we deliberately don't run ads on these episodes. No sponsors, no mid-roll interruptions. If you want to help keep it that way, the link is buy me a coffee dot com slash fexingo. Simple as that. Luna: It's a small gesture that makes a big difference for us. And it lets us keep drilling into topics like R-star without worrying about ad revenue. Lucas: Exactly. So back to R-star — one more thing I think is important. The fact that the neutral rate might be rising doesn't mean the Fed should just raise rates indefinitely. It means the threshold for what counts as restrictive has moved. And that's a subtle but crucial distinction. Luna: So if R-star is 1.5 percent real, and the policy rate is 2.5 percent real, that's only 100 basis points of restriction. Historically, that's pretty mild. Lucas: Right. In past tightening cycles, the Fed often pushed real rates 200 or 300 basis points above neutral. If they can't do that now because the neutral rate itself is uncertain, they might have to rely more on quantitative tightening or macroprudential tools. Luna: So R-star isn't just a theoretical curiosity. It's shaping the entire policy toolkit. Lucas: Exactly. And that's why, even though we can't see it, central banks will keep staring at it. Because the cost of being wrong is just too high.