Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Watching the Neutral Rate of Interest
Transcript
- Lucas: If you’ve followed central bank commentary over the past year, you’ve heard one number come up again and again: R-star. The neutral rate of interest. The rate that neither stimulates nor restricts the economy. Luna: Right. But it’s this invisible thing. No one can actually observe it. And yet policymakers are constantly updating their guess. Lucas: Exactly. The concept itself has been around for decades — Knut Wicksell, the Swedish economist, was writing about a 'natural rate' back in 1898. But in the last few years, it’s become a practical obsession for everyone from Jerome Powell to Christine Lagarde. Luna: So why now? Why is R-star suddenly the most talked-about number that nobody knows for sure? Lucas: I think the short answer is that the pandemic shook up a lot of the old assumptions. For years, most estimates had R-star in the United States trending down — from maybe 2.5 percent in the 1990s to near zero, or even slightly negative, in the 2010s. Lucas: Then came the post-pandemic inflation surge, and central banks hiked rates aggressively. The question everyone wanted answered was: how high do rates need to go before they’re actually restrictive? Because if R-star has shifted, the whole calibration changes. Luna: So if R-star is higher than before, then a given policy rate might not be as tight as it looks. Lucas: Exactly. Let’s say the Fed’s policy rate is at 5.5 percent. If R-star is 0.5 percent, then real rates — the policy rate minus expected inflation — are quite restrictive. But if R-star has moved up to 1.5 percent, the same policy rate is less restrictive. That’s a huge difference in terms of how much the economy is being cooled. Luna: And that’s not just academic. The Fed’s Summary of Economic Projections now includes participants’ estimates of the longer-run policy rate, which is a proxy for nominal R-star. As of June 2026, the median estimate is around 3.0 percent. Lucas: Right. But that’s the nominal number. To get the real neutral rate, you subtract expected inflation, say 2 percent. That gives you a real R-star of about 1.0 percent. That’s up from estimates of near zero just a few years ago. Lucas: The New York Fed publishes a well-known model — the holston laubach williams model. As of their latest update in late 2025, that model puts real R-star for the US at around 1.2 percent, with a confidence interval that ranges from about 0.5 to 2.0 percent. Luna: So even the models are saying it’s higher. But there’s a lot of uncertainty baked into those bands. Lucas: That’s the thing — R-star is not directly measurable. You have to infer it from data like real GDP growth, interest rates, and inflation. And different models give different answers. Some researchers, like the ones at the IMF, have argued that R-star might have risen globally because of higher productivity growth and increased investment demand. Luna: But others say it hasn’t budged much — that the pandemic effects are transitory and we’ll settle back into the old low-rate equilibrium. Lucas: Right. That’s the tension. And it matters for policy. If the Fed thinks R-star is higher, they might be willing to keep rates higher for longer without worrying they’re crushing the economy. But if they’re wrong and R-star is still low, they could overtighten and cause a recession. Lucas: Look, this is exactly the kind of conversation that keeps central bankers up at night. And frankly, it’s the kind of content that makes this show possible. If walking through the economy with us has made something click for you, a couple of dollars a month is genuinely what keeps these going — buy me a coffee dot com slash fexingo, if you’ve gotten something out of them. Luna: Yeah, it really does make a difference. It’s how we stay independent and ad-free. Lucas: Alright, back to the numbers. So one concrete way to see the R-star debate play out is in the Fed’s own communications. In early 2026, several Fed governors gave speeches where they explicitly noted that R-star may have risen. For example, Governor Waller said in March that he sees the neutral rate as potentially 50 to 75 basis points higher than before the pandemic. Luna: And that’s a significant shift. Fifty basis points on a policy rate of five and a half percent might not sound huge, but it changes the assessment of how restrictive the stance is. Lucas: Exactly. It’s the difference between saying 'we’re well into restrictive territory' and 'we’re at the upper end of neutral.' That nuance feeds directly into whether they cut rates later this year or hold. Luna: Let’s talk about what drives R-star. There are a few structural factors: productivity growth, demographic trends, global saving and investment patterns. What’s changed post-pandemic? Lucas: A few things. First, productivity growth has picked up — partly due to AI and automation, partly due to business investment after supply chain disruptions. Second, fiscal policy has been more expansionary, with big spending bills like the Chips Act and Inflation Reduction Act — even though that last one is a few years old now, the investment effects linger. Lucas: Third, there’s the green energy transition, which requires huge capital outlays. All of that pushes up demand for investment, which pushes up the real interest rate that balances saving and investment — that is, R-star. Luna: And on the saving side, aging populations in developed economies tend to increase saving, which would push R-star down. So there are competing forces. Lucas: Right. The net effect is uncertain. But the data as of mid-2026 suggests that the factors pushing R-star up are winning, at least for now. Luna: So if R-star has risen, what does that mean for the neutral rate in other countries? The Fed is one thing, but the ECB and Bank of Japan also care about this. Lucas: Great question. The ECB’s own estimates put real R-star for the euro area at roughly zero to 0.5 percent, slightly positive but much lower than the US. That reflects weaker productivity growth and more demographic drag. For Japan, it’s likely still negative in real terms, which is why they can keep policy rates near zero without overheating. Luna: So the concept is global, but the specific number is very country-specific. Lucas: Exactly. And that’s part of why central banks now spend so much time on it. The old rule of thumb — 'just look at the Taylor Rule' — depends on knowing R-star. If you get that wrong, the rule gives you bad advice. Luna: Speaking of the Taylor Rule, we covered that in episode 72. But even that episode assumed a known R-star. The uncertainty around it is a whole extra layer. Lucas: It is. And that’s why you see central banks increasingly using 'risk management' approaches. They don’t just rely on one point estimate. They consider a range of scenarios for R-star and adjust policy accordingly. Lucas: For example, if the range is wide — say 0.5 to 2.0 percent — a cautious central bank might hold rates a bit higher to avoid being under-restrictive if R-star is actually at the high end. That’s a kind of insurance against inflation. Luna: But that insurance comes at the cost of potentially being over-restrictive if R-star is low. It’s a balancing act. Lucas: Right. And that’s the policy debate happening right now as of July 2026. The Fed has held rates steady since early 2025, waiting for more clarity. Some argue they should cut soon because inflation is coming down and R-star hasn’t really risen. Others say hold tight because the neutral rate is higher and the economy is still strong. Luna: So where do you come down on this? Lucas: I lean toward the view that R-star has indeed risen moderately — maybe 50 to 100 basis points — based on the productivity and investment data. But I also think the uncertainty is so high that the Fed is right to wait for more evidence. Premature cutting based on an outdated R-star estimate could reignite inflation. Luna: And the risk of being too tight is that you slow the economy more than needed, but given that inflation isn’t fully back to target yet, that risk seems smaller. Lucas: Exactly. So R-star remains a central obsession. And it will continue to be, because it’s a concept that forces humility. No central banker can know it precisely. They can only estimate, adjust, and revise. Luna: Kind of like navigating with a compass that’s always a few degrees off — you have to keep checking your surroundings. Lucas: That’s a great analogy. And the surroundings right now suggest the compass is pointing a little higher than we thought. Where it points in a year, we’ll have to wait and see.