Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Determine the Neutral Rate of Interest
Transcript
- Lucas: So the neutral rate of interest — also known as R-star, the natural rate — it's this invisible benchmark that every central banker has in the back of their mind. And right now, in July 2026, it is getting a lot more attention than usual. Luna: Because the pandemic kind of scrambled the economy in ways that make older estimates look shaky. Lucas: Exactly. The neutral rate is the real short-term interest rate that's neither stimulative nor contractionary when the economy is at full employment and inflation is stable. In theory, if the policy rate is below R-star, policy is loose. Above it, policy is tight. Luna: But you can't observe it directly. So how do central banks actually estimate it? Lucas: Right, it's unobservable. So economists use models. The two most cited are from Laubach and Williams at the San Francisco Fed, and the extended version by Holston, Laubach, and Williams. They use a statistical framework that decomposes the real interest rate into trend and cyclical components, using data on GDP growth, inflation, and unemployment. Luna: And these models have been showing a pretty clear decline in R-star for decades. Lucas: Yeah, from around 3 percent in the 1980s to something like 0.5 percent or even negative in the 2010s. That's been a huge story in macroeconomics. The New York Fed also publishes its own estimate — the 'Natural Rate of Interest' series — and it tells a similar story. Luna: What's driving that long-term decline? Lucas: A few big forces. Aging populations mean slower labor force growth, which reduces potential output growth. Slower productivity growth since the early 2000s. And a global savings glut — think China, Germany, oil exporters piling up savings, pushing real rates down globally. All of that drags the neutral rate lower. Luna: But then the pandemic comes along, and suddenly we have huge fiscal stimulus, supply chain disruptions, inflation spikes. Could that push R-star back up? Lucas: That is the million-dollar question right now. Some economists argue that if the pandemic triggered a productivity boom — think remote work, automation, AI adoption — potential growth could be higher, which would lift the neutral rate. Others say the structural forces like demographics haven't changed, so R-star might stay low. Luna: And as of mid-2026, where do estimates land? Lucas: The latest Laubach-Williams estimate for the US is around 0.6 percent real. But there's a wide confidence interval. The New York Fed's measure is similar. The key point is uncertainty is higher than usual because the post-pandemic data is still short and noisy. Luna: If today was actually useful to you, the way these stay ad-free is listener support — buy me a coffee dot com slash fexingo. Lucas: Yeah, genuinely, if walking through the economy with us has made something click, that's exactly the kind of signal that keeps us going. And it's a small way to keep the show free for everyone. Luna: So back to the neutral rate — how do central banks actually use this in real-time policy decisions? It's not like they set the rate based on a model estimate. Lucas: No, they don't mechanically target R-star. But it's a crucial input into their assessment of the stance of policy. When the Fed publishes its Summary of Economic Projections, the longer-run federal funds rate — that dot — is essentially their estimate of the nominal neutral rate. Right now, the median long-run dot is around 2.8 percent, which implies a real neutral rate of about 0.8 percent if you subtract 2 percent inflation. Luna: So that dot is their collective guess at R-star plus 2 percent inflation. Lucas: Exactly. And if the actual fed funds rate is above that, the committee is saying policy is restrictive. Below it, accommodative. So when you hear a Fed official say 'policy is restrictive,' they're implicitly comparing the current rate to their estimate of the neutral rate. Luna: But if the neutral rate is so uncertain, there's a risk of misjudging the stance. Lucas: Huge risk. If you think R-star is 0.5 percent but it's actually 1.5 percent, then a policy rate of 3 percent might not be as restrictive as you think. You could be tightening less than intended. Or vice versa. That's why central bankers talk about 'data dependence' and 'risk management' so much. Luna: Is there a way to cross-check the model estimates with market data? Lucas: Yes. One approach is to look at breakeven inflation rates and real yields on Treasury Inflation-Protected Securities, or TIPS. The five-year forward real yield, five years forward — that's a market-implied measure of the expected real short rate far in the future, which should converge to R-star. Right now, that forward real yield is around 1.2 percent, a bit higher than the model estimates. Luna: So markets are pricing a higher neutral rate than the models? Lucas: That seems to be the case. But it could also reflect term premiums or liquidity issues. It's another piece of the puzzle. The Bank of Canada and the ECB also publish their own estimates, and they're all grappling with the same uncertainty. Luna: And the Bank of Japan? Their neutral rate is probably negative, given decades of deflation and low growth. Lucas: Right. The IMF's latest World Economic Outlook includes estimates for G7 economies. For Japan, the real neutral rate is estimated around -0.5 percent. That explains why the Bank of Japan keeps rates ultra-low even as inflation picks up. Luna: So the neutral rate is essentially the compass, but the compass needle is wobbling. Lucas: That's a great way to put it. And the wobble matters. If you're a central bank trying to bring inflation down to 2 percent, you need to know whether 4 percent nominal rates are tight enough. If R-star is higher than you think, you might need to raise rates more. If it's lower, you might overshoot and cause a recession. Luna: Has the Fed ever gotten this wrong before? Lucas: In the 1970s, they arguably underestimated the neutral rate, kept rates too low, and inflation spiraled. In the 2000s, some economists argue the Fed kept rates too low for too long, partly because they thought R-star was lower than it actually was, fueling the housing bubble. So getting the neutral rate wrong has real consequences. Luna: And now we're in a period where the neutral rate might be shifting structurally. Lucas: Exactly. The pandemic, the fiscal response, the green transition, AI — all these could lift potential growth and thus R-star. But demographics and high debt levels could pull it down. We won't know for years. That's why Chair Powell and other central bankers have been emphasizing 'humble' policymaking and relying on a range of models. Luna: So for the listener trying to follow central bank communication, what should they watch? Lucas: Pay attention to the longer-run dot in the Fed's SEP. Watch speeches where policymakers discuss the 'neutral rate' or 'R-star.' And look at the five-year forward real yield from TIPS markets. If those start moving significantly, it's a signal that the underlying view of the economy is changing. Luna: It's a bit like navigating by the stars — you can see the constellation, but you're never quite sure where you are. Lucas: That's the best analogy I've heard. And just like sailors, central bankers need to constantly check their bearings. The neutral rate is one of the most important — and most elusive — stars in the sky.