Navigating To Neutral

The secular forces that held down rates for forty years have not entirely changed.

This week’s shopping list included candy and gourmet popcorn to leave in the kids’ shoes as a surprise on the morning of St. Nicholas Day. They’re likely old enough to discern that a mythical old man isn’t working his way around the world offering treats. But even though St. Nick is unobservable, he is an important part of the season for them.

In economics, we reckon with a number of unobservable concepts and forces. The one we’re wrestling with most at the moment is the neutral rate of interest. Divining what the rate is and how it affects the economy is much more difficult than trying to deduce how shoes get filled with sweets at the beginning of each December.

The neutral rate, or r* (pronounced r-star) is the level of nominal interest rates that is at equilibrium: it balances the aggregate supply of saving with the demand for financing. When rates are at their neutral level, they are neither inflationary nor restrictive, neither encouraging excesses of debt nor holding business back with high costs of financing.

Deriving r* is not a simple calculation. We can only judge whether r* is achieved by the actual economic outcomes that surround it. The rate is a moving target, with circumstances pushing it higher or lower. Over time and across regions, r* will vary.

Difficult as the estimation may be, policymakers need some notion of r* in order to make decisions. Fed Chair Jerome Powell has made regular use of the analogy of navigating by the stars—most recently, “under a cloudy sky” in his Jackson Hole speech.

Federal Open Market Committee Members' Estimates of Long Run Fed Funds Rate