Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Watch R-Star So Closely
Transcript
- Lucas: The Federal Reserve released its June Summary of Economic Projections a couple of weeks back, and buried in those dot plots was a subtle but meaningful shift. The median estimate for the long-run fed funds rate — what economists call r-star — ticked up to 3 percent, from 2.8 percent in March. Luna: That is a small number, but it seems to be getting a lot of attention. Why does 20 basis points matter that much? Lucas: Because r-star is the theoretical interest rate that neither stimulates nor restricts the economy. If the Fed thinks it has risen, then the current policy rate of, say, 4.75 percent is actually less restrictive relative to that higher neutral. That could mean fewer rate cuts ahead, or none at all. Luna: So the whole rate path hinges on a number nobody can directly observe. Lucas: Exactly. And that tension is at the heart of the modern central banking debate. R-star is a concept that goes back to Knut Wicksell in the late 1800s, but it became a practical obsession after the global financial crisis, when rates stayed low for a decade and the Fed kept marking down its r-star estimate. Luna: Now it seems to be moving the other way. What is driving that shift? Lucas: There are three big forces in the current debate. First, fiscal deficits. The U.S. government is running large deficits even in a strong economy, which adds to the supply of government debt and pushes up term premiums. That effectively raises the neutral rate by increasing the return investors demand to hold long-term bonds. Luna: That makes sense. More supply, higher yields. What is the second force? Lucas: Investment demand tied to AI and reshoring. The buildout of data centers, semiconductor fabs, and clean energy infrastructure is capital-intensive. If the economy needs more investment, the real rate that balances savings and investment should be higher. Luna: And the third? Lucas: Demographics. Aging populations in developed economies tend to reduce labor supply and increase savings. That pushes r-star down. So you have two upward forces — fiscal and investment — and one downward force — demographics. The net direction is uncertain, and different models give different answers. Luna: But the Fed's dot plot suggests they think the net is up. At least a little. Lucas: Right. And that has real consequences. If the neutral rate is actually 3 percent, then the current fed funds rate of 4.75 percent is about 175 basis points above neutral. That is still restrictive, but less so than if r-star were 2.5 percent. It means the economy can tolerate higher rates without tipping into recession, which argues for a slower pace of cuts. Luna: And if the Fed gets r-star wrong? What happens then? Lucas: If they overestimate it, they keep policy too tight for too long, risking a downturn. If they underestimate it, they cut too soon and inflation reignites. That is the policy dilemma. Luna: So how do central banks actually estimate this number? I know they use models, but can you sketch out the approach? Lucas: Sure. The most common framework is the Laubach-Williams model, which uses a Kalman filter to extract r-star from data on GDP, inflation, and the real interest rate. It essentially treats r-star as a slowly moving trend that you infer from the economy's behavior. The New York Fed publishes a quarterly estimate. As of early 2026, their model put r-star for the U.S. at around 1.2 percent — well below the 3 percent dot plot. Luna: That is a big gap. One point eight percentage points between the model and the FOMC's median. How do you reconcile that? Lucas: You don't fully. The dot plot is a judgment call by 19 individual FOMC participants. Some may be incorporating factors the model doesn't capture — like the fiscal outlook or structural changes in the post-pandemic economy. Others might just be more hawkish. The divergence itself tells you how uncertain the concept is. Luna: I remember former Fed Chair Bernanke once called r-star 'a largely academic concept.' But it's clearly driving real policy. Lucas: And that is exactly what makes this topic so interesting. A few months ago, the Bank of England's chief economist said that the UK's neutral rate may have risen by about 50 basis points due to fiscal and investment factors. The European Central Bank is also debating whether r-star has ticked up. This is not just a U.S. conversation. Luna: Speaking of conversations, we should mention that we deliberately keep these episodes free of ads. If walking through the economy with us has made something click, and you want to support that choice, there is a link at buy me a coffee dot com slash fexingo. It's a simple way to keep the show independent. Lucas: Yeah, and we appreciate everyone who does that. So going back to the data — there is another angle to r-star that often gets overlooked. It's not just a level; it's also a dynamic concept. The neutral rate can shift over time in response to shocks. Luna: Like the pandemic? Lucas: Exactly. The pandemic caused a massive increase in household savings and a collapse in investment, which temporarily pushed r-star down. Then the fiscal response and reopening pushed it back up. That kind of volatility makes it even harder to pin down. Luna: And markets seem to be pricing in a higher neutral rate too. The term premium on the ten-year Treasury has risen since 2024. Lucas: Right. The term premium is the extra yield investors demand for holding long-term bonds beyond what short-term rate expectations imply. It's been positive again after years of being negative. That aligns with the idea that the neutral rate has risen, but it's also driven by supply and demand dynamics in the Treasury market. Luna: So if the Fed's r-star estimate is too high, and they hold rates higher for longer, what should listeners watch for as a signal? Lucas: I would watch the labor market closely. If the unemployment rate starts rising faster than the Fed expects, that could be a sign that policy is tighter than they realize. Also watch inflation breakevens — if they fall below 2 percent, it suggests the market thinks the Fed is overdoing it. Luna: And if r-star is actually higher, what would we see? Lucas: Then inflation would stay sticky even with rates at current levels, and the economy would continue growing above trend. That scenario would validate the higher dot plot and mean fewer cuts in 2026 and 2027. Luna: It seems like r-star functions as a kind of compass that keeps getting recalibrated. And the navigation is anything but straightforward. Lucas: Exactly. The compass points in a direction, but the magnetic north keeps moving. For now, the Fed's compass suggests a slightly higher neutral. Whether that turns out to be accurate will shape the next several years of monetary policy. Luna: I guess we will be watching the data — and the dot plots. Lucas: Always a good plan.