R-stargazing: Part one

Summary

With the first rate cut from the FOMC looking increasingly likely to occur in the next few months, a new debate has gathered momentum: what is r* in today's economy, and where is it headed in the future?

R* (pronounced "R-star"), also known as the natural rate, the neutral rate or the equilibrium rate, is the real (i.e. inflation-adjusted) policy rate that would be expected to prevail over the longer-run with inflation anchored at the central bank's target. In other words, r* is the real short-term interest rate that neither speeds up nor slows down the economy in equilibrium.

Understanding r* is critical to financial markets and policymaking. An accurate estimate of r* can help central bankers craft monetary policy in a way that meets the needs of the economy at a given point in time. An investor considering whether today's 10-year Treasury note is an attractive investment must weigh not just what short-term interest rates will be over the next year or two but what they will be for the entire next decade.

Measuring r* is an inherently tricky task. One of the defining characteristics of the natural rate is that it is not directly observable. Unlike employment growth or inflation for consumer goods, r* is a theoretical construct that cannot be sampled. Economists must rely on a variety of tools and methods to estimate r*, and there is inherent uncertainty around those projections.

Looking across a wide range of measures, including econometric models, financial market instruments, Federal Reserve forecasts as well as private sector economist forecasts, we believe a reasonable range of consensus estimates for r* in the United States at present is ~0.75% on the low side and ~2.50% on the high side, with the median forecast probably closer to the bottom end of that range.

But what determines r* in the first place? At its core, r* is the market clearing rate for the supply of and demand for savings. Firms and governments demand capital to finance new projects, while the supply of capital originates from savers seeking to earn a rate of return in exchange for delaying consumption.

Many factors impact the supply of and demand for savings. Over the past few decades, a few forces have put upward pressure on r*, such as an explosion in public debt. However, other factors such as slower productivity growth, an aging population, new financial regulations and a global savings glut have more than offset the upward pressure on r* from fiscal deterioration. These structural changes explain the steady decline in r* and in U.S. interest rates more generally that began in the 1990s and lasted until a few years ago.

But as we look to the years ahead, will low real rates continue to be the norm? The experiences of the past few years have led to a revisiting of that assumption. Questions abound about the outlook for accelerating labor productivity, rapidly declining birth rates, deglobalization and ballooning public debt. In Part II of this series, we will examine the outlook for these factors and lay out our base case forecast for r*.

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