Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Estimate the Neutral Rate of Interest
Transcript
- Lucas: In late 2025, the New York Fed updated its estimate of R-star for the U.S. economy. It dropped to 0.75 percent — the lowest since the pandemic. That number, the neutral rate of interest, is quietly the most important input in central bank policy. Luna: R-star — the theoretical rate that neither stimulates nor restrains growth. Most people have never heard of it, yet it dictates where the Fed thinks rates should ultimately settle. Lucas: Exactly. And it’s been falling for decades. In the 1990s, the median estimate was around 4 to 5 percent. After the 2008 financial crisis, it dropped to near zero. The pandemic pushed it even lower, and despite a brief spike in 2022 and 2023, it’s now settling back down. Luna: So what drives that decline? Is it demographics, productivity, global savings — or all three? Lucas: All three. The most cited model, the Laubach-Williams framework, uses trend growth, the output gap, and inflation dynamics. It attributes most of the decline to slower potential growth and an aging population that saves more and invests less. A 2024 paper from the San Francisco Fed found that demographic shifts alone could account for half the drop since 2000. Luna: But R-star isn’t directly observable. Economists are essentially guessing based on a model. How much does the estimate vary across different approaches? Lucas: A lot. The holston laubach williams model gives one number, but the Congressional Budget Office uses a different framework and currently puts the neutral rate closer to 1.2 percent. The Atlanta Fed’s survey of primary dealers shows a range from 1.0 to 1.5 percent. And some academics argue R-star might even be negative in real terms. That uncertainty has real consequences. Luna: Because if the Fed thinks R-star is 0.75 percent, but it’s actually 1.5 percent, then policy is less restrictive than they believe — and they might stop cutting rates too early. Lucas: Right. That’s the risk. Conversely, if R-star is lower than estimated, the current 5 percent fed funds rate is extremely tight, and the economy could slow abruptly. The Taylor rule — which central banks use to set rates — is only as good as the R-star input. A miscalculation of half a percentage point can mean the difference between a soft landing and a recession. Luna: Speaking of appreciation for these fine-grained policy details — if walking through the economy with us has made something click, a couple of dollars a month genuinely keeps these episodes ad-free. You can find us at buy me a coffee dot com slash fexingo. Lucas: Yeah, listener support makes a real difference. We keep it independent, no sponsors, just the economics. Every little bit helps. Luna: Now, the debate about R-star has gotten heated recently. Some Fed officials, like Christopher Waller, have argued that the neutral rate may have risen permanently due to higher government debt and green investment. Others, like Lael Brainard before she left, insisted the structural factors are still pushing down. Lucas: That’s the core tension. The pandemic fiscal stimulus and the Inflation Reduction Act have boosted investment demand, which could raise R-star. But at the same time, aging populations in developed economies and China’s excess savings are still exerting downward pressure. The BIS put out a paper in early 2026 showing that global R-star has actually ticked up for the first time in two decades, but only by about 20 basis points. Luna: So we might be in a more regime where R-star stabilizes around 1 percent rather than zero. That would still be low by historical standards, but higher than the post-2008 trough. Lucas: And it matters for every central bank. The ECB’s estimate for the euro area is even lower — around zero or slightly negative in real terms. The Bank of Japan has been stuck with a negative neutral rate for years. That’s part of why their yield curve control was so hard to unwind — when your R-star is negative, any positive policy rate is restrictive. Luna: So the next time you hear a Fed official say ‘policy is well into restrictive territory,’ what they really mean is ‘given our estimate of R-star, we’re tight.’ But that estimate could be wrong. Lucas: Exactly. And that’s why the debate matters so much. The neutral rate isn’t just an academic curiosity — it’s the compass for monetary policy. A wrong compass leads you off course. The real challenge is that we can never see R-star directly. We can only infer it from how the economy behaves. And if the economy behaves in unexpected ways — like low inflation despite low unemployment in the 2010s — that suggests R-star might be even lower than models say. Luna: So looking forward, if the Fed achieves a soft landing this year, and inflation stays around 2 percent, will we get a clearer reading on where R-star actually is? Lucas: Only if the economy settles into a steady state. The problem is that R-star shifts over time, and the models have a lag. The New York Fed’s estimates are updated quarterly, but they incorporate data from the previous decade. So by the time we confirm a new level, the underlying forces might have changed again. It’s like trying to hit a moving target in the fog. Luna: That’s a sobering thought. Central banks are making decisions every six weeks based on a number that’s inherently unknowable. Lucas: And they’re aware of it. That’s why the dot plot now includes a longer-run federal funds rate projection, which is essentially the FOMC’s collective guess of R-star. In mid-2026, that median dot is at 2.5 percent — well above the Laubach-Williams estimate. That gap itself tells you how much uncertainty there is. Luna: So what’s the one concrete takeaway for a listener who wants to understand where rates are headed? Lucas: Watch the neutral rate debate. If the consensus R-star moves up, the Fed can keep rates higher for longer without worrying about over-tightening. If it stays low, they’ll need to cut more aggressively to avoid a recession. The neutral rate is the linchpin — and for now, it remains the ghost in the machine of monetary policy. Luna: Ghost in the machine. That’s a perfect description for a number we can’t see but can’t ignore. Lucas: And it’s a reminder that even in the data-driven world of central banking, judgment and models are all we have. As the old saying goes, ‘We don’t know where R-star is, but we know where it isn’t.’ Right now, it isn’t at zero — but it isn’t back to 4 percent either.