As the Federal Reserve gradually normalizes its monetary policy, market participants will hear a lot more about r*, the “neutral rate of interest,” which helps equilibrate financial markets when the economy is growing at potential and inflation remains contained and stable.
Should central banks hike interest rates well beyond this level, they will harm growth, threaten recession and deflation, and impose avoidable costs on society. Should they maintain rates below that level for too long, they will run the economy too hot, see future inflation eat away at the purchasing power of households, and also risk financial market instability that would further harm social welfare.
This potential boom-bust tightrope also relates to why r* is important for markets. A gradual convergence of the policy rate to that level would allow, to adapt the phrase of Bridgewater Associates’ Ray Dalio’s, a “beautiful normalization” of monetary policies that is consistent with market stability and soundness.
Should central banks overshoot r*, they will hamper the improvement in economic fundamentals needed to validate existing asset prices, thus risking market instability as prices ultimately converge back down to the weaker economic conditions. And should they instead undershoot r*, they risk fueling bubblish financial conditions that not only render asset prices unsustainable over the medium-term but also threaten the real economy as markets subsequently collapse in what, judging from history, could be a sudden and disorderly fashion.
Here are the 10 key things to know about this concept:
1. As r* acts as the North Star for the gradual normalization of policy rates, it also helps to anchor market expectations about the destination of the front end of the yield curve, though not the exact path and precise shape of the curve in its entirety.
2. The determinants of r* are primarily domestic and include such secular and structural variables as productivity, demographics, regulation and financial deepening. Nonetheless, international influences have been playing a larger role in a world of high financial globalization with global common factors becoming more important. Also of importance is a monetary policy stance that has been forced in recent years to try to compensate for shortfalls elsewhere (from the relative paralysis of fiscal and structural reforms to the worsening of inequality that lowers the economy’s marginal propensity to consume).
3. This mix of domestic, international and policy factors has an important impact on the relationship between interest rates and the exchange rate. The greater the domestic influences, the stronger the relationship between moves in r* and in foreign-exchange markets.
4. Once thought to be relatively constant, including under the Taylor Rule that has guided the thinking of many central bankers over the years, the level of r* is believed to have declined significantly since the global financial crisis. This has been highlighted in work by Richard Clarida, my former PIMCO colleague and Columbia University professor, and others such as Thomas Laubach and John Williams, as well as the International Monetary Fund and the Federal Reserve system. But its precise specification remains the subject of much debate, adding to the even more contentious discussion about the desirability and feasibility of a regime shift to a rule-based monetary policy.
5. Amplifying the analytical challenges is the fact that r* is not directly observable. It must be deduced from models that incorporate both economic and financial variables that cover both the public and private sectors, domestic and foreign.