“R-star”: less cherished, but still useful
The latest macro data and the higher confidence shown by the Fed in its mildly reflationary outlook have increased the conviction that rates will continue to increase at a quarterly pace well into next year.
Authors: Paolo Zanghieri
- Whether and when the Fed will have tightened too much is an issue that is gathering attention: One way to look at it is to compare the level of fed funds rates against the equilibrium short term interest rate (R-star), i.e. the rate consistent with balanced growth. In the past, policy rates rising above R-star preceded a recession by few quarters.
- R-star is not observable and must be estimated with models. The wide range of estimates raises questions on its value as a gauge of the monetary policy stance and the Fed is downplaying its role. However, we show that it can still provide useful insights, especially on yields and bond-equity correlations.
- The mild increase in potential growth and the wider fiscal deficit should raise R-star from its historically lows to levels consistent with a nominal rate of around 3%. However, adverse demographic trends will cap its upside potential.
- Its very gradual and limited increase will widen the gap with respect to the Fed funds rate, resulting in a mildly tight monetary policy.