R-star: How useful is it in practice?
The nature of how r-star (r*) is calculated makes it a useful concept for evaluating the stance of monetary policy and assessing longer-term asset values. The only issue is that historically it hasn’t proven very accurate at determining the level of cash rates even over longer timeframes. Accordingly, understanding the limitations of r* is an important step in ensuring it is used appropriately.
Is r* an accurate indicator of monetary policy?
The concept underlying the traditional means of calculating r* is that real longer-term factors determine the neutral cash rate around which central bank policy will be formulated. Implicit in the calculation of r* is the assumption that, in the long run, economies will tend to equilibrium and that monetary policy, though it may have short-term impacts, ultimately only impacts inflation. The benefit of such a formulation is that it facilitates a more stable relationship, where changes are driven by reasonably slow-moving variables (1). Yet for r* to be viewed in practice as an unbiased estimate of the neutral cash rate, requires actual cash rates, i.e. the key policy tool of central banks, to oscillate around it as the stance of monetary policy moves from expansionary to contractionary over the cycle. Put another way, the actual cash rate should be normally distributed around the neutral cash rate predicted by r*.
Looking at data from the 1970s to the present, it appears that r* fails to satisfy the criteria of an unbiased estimate of the neutral cash rate. In Figure 1 below, we compare the Federal Reserve Bank of New York’s estimate for the US r* with the real Fed Funds rate (RFFR) (2).
For most of the period since the 1970s, the RFFR was materially below r*. Indeed, r* appears to be more of an upper limit for the RFFR rather than anything approximating an average. This can be more clearly seen by taking a longer-term perspective and considering the average values for r* and the RFFR for each decade since the 1970s (see Figure 2 below).
The averages for each decade highlight that, not only has r* been declining over time, the RFFR has generally tended to lie materially lower than the estimate of r*. Indeed, apart from the early 1980s, r* would appear to have served more as an upper limit for the RFFR. This bias is particularly well illustrated by considering the impact of moves in Fed Funds rates from 2005 as the US Federal Reserve (Fed) started moving it back towards r*. The result of the move back to r* was the global financial crisis (GFC), which began in 2006 with the collapse of Bear Sterns and reached its crescendo in 2008 with the collapse of Lehman Brothers. Put another way, the impact on the financial system and the economy from the Fed’s attempt to move the RFFR back in line with r* was financial meltdown and recession. If nothing else, this highlights that the level of r* indicated by the traditional models was materially higher than the debt levels at the time could withstand. This may have been the first indication that the past actions of the Fed, i.e. overly accommodative monetary policy in the preceding decade, had structurally impacted r*.
The central problem with r*: Changing central bank policy reaction functions
The events of the mid to late 2000s highlight that the central problem with r* is that it ignores the evolving nature of the policy reaction function of central banks. Effectively, the way that r* is calculated assumes that central bank policy reaction functions are exogenous to the neutral cash rate. This is a major limitation, as such policy reaction functions evolve over time as economic developments evolve. As G.W.F Hegel stated, “Each period is involved in such peculiar circumstances, exhibits a condition of such things so strictly idiosyncratic, that its conduct must be regulated by considerations connected with itself, and itself alone.” Yet r* ignores period-specific drivers in favour of longer-term dynamics.
It is this ignoring of changes in central bank policy reaction functions that may lie behind the particularly poor performance of r* post the 1990s. With inflation remaining low, central bankers appear to have altered their policy reaction functions and adopted more of a pro-growth bias. A by-product of this pro-growth bias was a material lowering of the real interest rate and increased tolerance by central banks of a structural increase in the level of debt within the economy. Though such a bias existed prior to the GFC in 2008, and indeed probably was partly responsible for the GFC, the response of central banks since this event more clearly illustrates the change in policy reaction functions. The initial response of central banks around the world was to provide large amounts of liquidity to the financial system in order to accommodate the rush toward risk-free assets, i.e. cash. This is the typical response to such a financial crisis and serves to limit its immediate impact so that financial institutions and borrowers can undertake a more orderly rebasing of liabilities via restructuring and default over a longer timeframe. Accordingly, it is usually seen as an emergency action to deal with a shorter-term liquidity crisis within the financial system. However, it may be argued that something changed subtly as time went by. From providing emergency liquidity to facilitate the orderly rationalisation of debt, quantitative easing (QE) morphed into a tool for supporting growth by encouraging/accommodating the taking on of more debt.
This morphing of QE was the unfortunate consequence of central banks’ increased focus on encouraging growth being in natural tension with the need for a general rationalisation of balance sheets. Given this conflict, the focus would appear to have been to support growth. This is not to say that there was an explicit decision by central banks to encourage debt accumulation, but rather that debt accumulation was the necessary by-product of the more growth-oriented focus of monetary policy. The result has been an encouragement of ‘zombie’ households and corporations where debt levels have reduced the ability to consume and invest. What was created was a feedback loop whereby increased debt levels act as a headwind to growth, thereby limiting the ability of central banks to raise rates without adversely impacting the very growth they are trying to support. By focusing on longer-term variables, r* ignored the shift in the central bank’s policy reaction function and hence materially overstated the neutral cash rate from the 2000s onwards.
Looking forward: pro-growth bias of central banks is reinforced
When considering the future evolution of policy reaction functions, the key dynamic resulting from the coronavirus pandemic is the material increase in fiscal deficits. The need for governments to significantly increase expenditure and bond issuance meant that there was additional pressure on central banks to accommodate further increases in debt. Such accommodation meant material increases in the supply of funds to markets to prevent government borrowing costs from being pushed too high.
Aside from the immediate impact, there is also a potentially more insidious effect from the increase in government debt; namely strengthening of the pro-growth bias of central banks. For any government faced with excessive debt, there are few options to reduce debt outside of deflationary measures such as expenditure cuts and tax increases. Two of the more obvious ways to reduce debt without inducing economic deflation are:
1. Financial repression so that the real value of debt is reduced over time; or
2. Stronger growth so that the amount of debt to gross domestic product (or tax base) is reduced.
Financial repression, whilst potentially attractive, is harder to implement in the absence of capital controls and materially higher levels of inflation (3). This implies that going forward, the pro-growth bias of both governments and central banks is likely to be strengthened as governments try and work their way out of the elevated debt levels they currently face. Such a pro-growth bias heightens the risk that models drawing upon economic fundamentals risk materially misestimating the actual neutral cash rate being targeted by central banks.
The traditional means of calculating r* can act as a useful guidepost for linking the neutral cash rate to longer-term economic fundamentals. Unfortunately, its historical linkage to actual cash rates, even over the longer term, has proven quite tenuous. Attempts have been made over time to realign r* estimates with the observed cash rates though these are generally being done on an ex-post basis. Despite this, given the magnitude of the more recent declines, the current r* estimates at close to zero are less likely to exhibit the upper bound characteristics historically observed. Whether they prove any more accurate as indicators of neutral central bank policy remains to be seen. Of course, even if there are deviations this is not to say that in the longer term the fundamentals behind traditional estimates of r* may not prove accurate. However, as John Maynard Keynes stated succinctly regarding the assumption that in the long run economies naturally revert to equilibrium: “In the long run we are all dead.”
(1) For those wanting more detail on the factors impacting estimates of r* please refer to the Livewire article “The search for the elusive ‘R-star” : What it means for monetary policy”.
(2) The RFFR is calculated by taking the 12-month rolling average and deducting the year-on-year change in the US consumer price index.
(3) A closer look at the topic of financial repression will be the subject of a Livewire article to be released next month.
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Clive Smith is the Senior Portfolio Manager on Russell Investments’ Australian fixed income team. Responsibilities span management of Russell Investments’ Australasian fixed income funds as well as conducting capital market and manager research...