“R-star”: less cherished, but still useful

Highlights:

• 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.

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