The Daily Update - The FED and R-Star

New York Fed President Williams was speaking yesterday and we thought his comments needed further investigation, he was speaking about the Fed neutral rate:

‘In addition, as we have moved far away from near-zero interest rates, it makes sense to shift away from a focus on normalizing the stance of monetary policy relative to some benchmark ‘neutral’ interest rate, often referred to as ‘r-star.’ … Having said that, at times r-star has actually gotten too much attention in commentary about Fed policy. Back when interest rates were well below neutral, r-star appropriately acted as a pole star for navigation. But, as we have gotten closer to the range of estimates of neutral, what appeared to be a bright point of light is really a fuzzy blur, reflecting the inherent uncertainty in measuring r-star. More than that, r-star is just one factor affecting our decisions, alongside economic and labor market indicators, wage and price inflation, global developments, financial conditions, the risks to the outlook’.

Williams has been a big supporter of r* over the years! Broadly speaking, the central bank rate-setting framework relies on some combination of both realised incoming economic data, which is generally backward looking, with model-based or theoretical constructs such as r*, which would tend to be more forward looking.

An example would be the Taylor rule that takes past data as an input but compares it to theoretical constructs such as potential GDP in order to prescribe a rate-setting relative to the estimate of r*. But the recent comments by Powell and Williams show an increasing uncertainty around these theoretical signposts. There is a debate on going as to what this might mean for the current path of policy – does it cut hawkish or dovish?

On the dovish side, less certainty about where neutral is could lead to more caution on the part of the Fed as they worry about potentially overtightening. While on the hawkish side less reliance on r* might lead the Fed to be more reactive to incoming data and more likely to tighten too much. The debate continues.

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