09-12-2024
The inflation gap and the unemployment gap inform the Federal Reserve as to how to calibrate or steer monetary policy to achieve their dual mandate. An important question is where is the “destination” for monetary policy? That is, where should the Fed’s policy rate end up when it has successfully closed both the inflation gap and the unemployment gap?
We can call this level of the policy rate the “neutral” policy rate. If the inflation gap is zero, then underlying inflation is at the Fed’s target of 2 percent. This means that the Fed’s neutral policy is the natural real interest rate plus 2 percent. Macro economists often call this natural real interest rate “r-star or r*.” Like the natural rate of unemployment used to measure the unemployment gap, r* cannot be directly observed and must be estimated.
Conceptually, r* is the appropriate short-term real interest rate consistent with the economy growing at its potential. The level of r* should induce enough savings to fund desired investment in an environment of trend growth in the economy. This implies that r* should reflect demographic changes as these affect aggregate savings. As the population ages, individuals shift from being borrowers to savers leading to higher aggregate savings and, others factors constant, a lower r*. Firm investment demand depends on trend productivity growth which reflects the return to capital investment. If trend productivity growth is slowing, then this reduces the demand for capital and, other factors constant, will lower r*. Similarly, if productivity growth is increasing — say due to adoption of AI — then the demand for capital will be higher and will raise r*. The degree of “risk appetite” in the economy also influences r*. Recently, large persistent Federal deficits would be expected to increase r* as investors require a higher return to absorb the significant increase in the issuance of Treasury securities.
On any journey it is important to know how far you are from your destination. As the Fed begins to reduce its policy rate, market participants like kids on a long car ride will constantly be asking “are we there yet?” If r* is 0.5 percent, then the Fed should be steering the economy to a neutral policy rate of 2.5 percent. This is almost 3 percentage points below the current policy rate. On the other hand, if r* is 1.5 percent, then the Fed should be steering the economy to a neutral policy rate of 3.5 percent — a closer destination. In the next post, I will discuss estimates of r* as well as the historical view by the Fed as to what it thinks the level is for r*.
Joseph Tracy is a Distinguished Fellow at Purdue University’s Daniels School of Business and a nonresident senior fellow at the American Enterprise Institute. Previously he was executive vice president and senior advisor to the president at the Federal Reserve Bank of Dallas.
