The search for the elusive "R-star": What it means for monetary policy
The fundamental failing of using "r-star" as one of the cornerstones of monetary policy is that it cannot be directly observed.
This makes the more recent behaviour of r-star - a more than century-old shorthand for the natural rate of interest or "real interest rates" that has risen in prominence again in recent years - particularly troubling for central bankers. The heightened uncertainty created by this more recent behaviour of r-star is likely to have material impacts on how central bankers conduct monetary policy going forward.
What is r-star and why does it matter?
R-star is what economists refer to as the natural rate of interest, or the real interest rate expected to prevail when the economy is at full capacity. Put another way, it is the real interest rate that is neither expansionary nor contractionary when the economy is at full employment, i.e. equilibrates the economy in the long run. As such, r-star has been viewed by many economists as being a fairly stable variable driven by longer-term economic factors beyond the influence of central bankers and monetary policy; i.e. it can be considered an independent economic variable when setting monetary policy.
Despite its importance, the focus on r-star as a cornerstone of monetary policy setting is a relatively recent phenomenon. While referred to by Knut Wicksell as early as 1898, it didn’t come to prominence until the early 2000s. Its recent rise in significance began with Michael Woodford (2003), who argued that “a central bank should seek to close the gaps between actual economic conditions and the economy’s potential for output and employment as well as the gap between actual real interest rates and the natural rate (r-star) all at the same time to obtain an optimal outcome.” As central bankers increasingly focused on inflation as an objective of policy, the importance of accurately estimating r-star grew in significance, as it anchors where short-term interest rates will need to be in the future. This is particularly important given the long and variable lags associated with implementing monetary policy. The result is that r-star became one of the key lynchpins behind the determination of the appropriate stance of monetary policy over the longer term. The theory goes that if central bankers set the base rate below/above r-star then monetary policy is accommodative/restrictive, thereby pushing inflation toward its target over the longer term.
What has r-star done?
While this all sounds fine in theory, the central issue with r-star in practice is that it cannot be observed. However, this doesn’t mean there haven’t been methods utilised to try and estimate what r-star may have done over time. The key problem with such estimates of r-star is that they contain a high level of uncertainty. Accepting this caveat, and using estimates from the Federal Reserve Bank of New York, r-star declined dramatically following the global financial crisis in 2008 after having fluctuated around 2.5% from 1985-2008.
Such a large shift in r-star was a surprise, as many economists had assumed that r-star would move in line with longer-term trend growth. The shift in r-star’s relationship with trend growth post-2008 raised the question of whether the decline was simply a shorter-term dynamic which would correct over time as global economies and macro policies ‘normalised’ or the beginning of a more permanent shift down in r-star.
But what determines r-star?
In assessing the outlook for r-star, it is important to keep in mind that r-star is determined by longer-term macro factors. At a very high level, the value of r-star is determined by the interaction of the quantity of savings and investment. In any economy, the level of savings must, in the long run, equal the level of investment. The r-star is accordingly the value of interest rates which attract enough savings to bring around equilibrium between the two variables. Though the drivers of savings and investment can be formulated in different ways, the main factors impacting the supply and demand for savings are often considered to be:
- Changes in the relative size of the workforce and population characteristics can directly impact consumption, savings, economic growth and investment.
- The level of productivity will impact the investment opportunities available and therefore the demand for capital. This factor is often impacted by technological change which can be difficult to predict.
Demand for safe assets
- The level of risk aversion exhibited by investors may not only impact the level of savings but also the demand for safe assets, thereby influencing the yields for government securities and safe short-term assets.
To highlight how these factors may impact on r-star, it is useful to consider some of the arguments around how each of these factors could push r-star up or down.
Potential dynamics pushing r-star down:
- Labour force growth slows as baby boomers retire. Coupled with lower fertility rates, this reduces consumption and investment.
- As life expectancy increases, the amount saved for retirement also increases, pushing up savings.
- The productivity boom of the 1980s to 2000s, driven by computerisation and the internet, has largely run its course, meaning lower levels of productivity growth going forward.
Demand for safe assets
- Structural increase in risk aversion post-2008 has permanently increased savings rates and demand for safe assets.
Potential dynamics pushing r-star up:
- The retirement of baby boomers will reduce savings as they stop working and start drawing down existing savings.
- Environmental change and the associated need for increased ‘green’ investments will materially boost investment demand.
- Ongoing ‘digitalisation’ of the workplace will see worker productivity continue to increase.
Demand for safe assets
- Demand for safe assets and savings rates will normalise as economic/financial conditions and interest rates move back toward longer-term values.
As can be seen, quite solid arguments can be put forward for why the macro factors influencing r-star should be either keeping values low or pushing them materially higher.
Implications for monetary policy
R-star has quite rightly been described by the US Federal Reserve as “a rare kind of navigational aid, as it becomes blurrier as it gets closer.” It is for this reason that the uncertainty created by the apparent shift in r-star is of significance for central bankers when setting monetary policy. To see why, consider that with interest rates around zero, the importance of r-star is reduced as central bankers can be reasonably confident that, even allowing for the inherent uncertainty in estimating r-star, they are comfortably below it. The importance of knowing the exact position of where r-star becomes more important as central banks raise interest rates back to more ‘normal’ levels. At this point, the risk is that policymakers could perceive r-star to be either higher or lower than its actual value.
Given the risks in misestimating where r-star is, it now becomes more important to consider the potential cost associated with such a misestimate. As central bankers are wanting to push inflation higher, after an extended period of undershooting targets, the costs would appear higher if policymakers mistakenly assume that r-star is greater than its true value. The result of such a misestimate would be to set cash rates too high, thereby creating longer-term downward pressure on growth and inflation. This suggests that with cash rates at or close to the lower bound, policymakers may prefer to act under an initial assumption of a materially lower r-star. Such a behavioural bias would point to central bankers erring toward an initial r-star estimate of no more than 1%, i.e. assume initially that r-star in the longer term is around current estimated levels. The estimates would then be adjusted over time as the central bankers observed the impact of monetary policy on growth and inflation. A policy reaction function along these lines implies a more gradual normalisation of cash rates globally when the time comes to lift off the effective lower bound, i.e. understating r-star when setting policy is more consistent with achieving the inflation targets of central bankers.
The potential shift in r-star post-2008 has materially raised the level of uncertainty around where its value lies. Despite the debate over whether the decline post-2008 is permanent, or will reverse over time, the impact of the heightened level of uncertainty on the setting of monetary policy is likely to be material. The increasingly ‘hit and miss’ approach required to determine where r-star lies means that central bankers are also increasingly sensitive to the costs associated with misestimations. When balancing these potential risks associated with misestimating r-star, central bankers are more likely to err toward underestimating its true value. Adopting such a bias is logical, as it reduces the opportunity costs associated with the objective of raising inflation back toward the longer-term targets. The result is likely to be central bankers adopting a more ‘gradualist’ approach to raising interest rates as they feel their way toward a better understanding of where the value for r-star truly lies.
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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...