The R-Star Wars Erupt into the Open
Recent remarks from key figures like Dallas Fed President Lorie Logan and Minneapolis Fed President Neel Kashkari are now shedding light on who might be included in that group and their growing concerns that r-star could be higher than previously estimated.
Economists use the abbreviation r* or r-star to refer to the neutral rate of interest. That, in turn, refers to an unobservable interest rate that is neither accommodative nor restrictive. It’s the interest rate you would expect if the Fed is hitting its goals of price stability and maximum employment. You are permitted to call it the “long-run equilibrium rate of interest”—but only if you are wearing tweed.
When the Fed says that the stance of monetary policy is restrictive, it means that rates are set significantly above r-star. If monetary policy is accommodative, rates are below r-star.
But what if the Fed is wrong about r-star? If r-star is significantly higher than the Fed thinks, rates may be accommodative when the Fed thinks they are restrictive. So, if the Fed thinks r-star is half a point above inflation—as it does now—it will look at the current federal funds range of 5.25 percent to 5.5 percent as very restrictive. But if it is really two or three points above inflation, then current rates might not be restrictive at all.
Logan and Kashkari argue that r-star might be higher than currently estimated. Logan points to factors such as unsustainable fiscal spending that could further elevate r-star, necessitating a more aggressive policy stance to combat inflation effectively.
Kashkari recently highlighted that the resilience of the housing market and strong labor market may indicate that current rates are not as restrictive as needed.
Kashkari has said he raised his forecast for the longer-run neutral rate from two percent to 2.5 percent, underscoring the need for possibly higher rates to curb inflation. Some of his colleagues on the Federal Open Market Committee have also raised their estimates, with the median forecast of the longer-run fed funds rate increasing to 2.6 percent from 2.5 percent in the latest projections published in March.
On the other side, New York Fed President John Williams and Fed Governor Christopher Waller suggest that r-star remains relatively low. Williams emphasizes the complexity of accurately estimating r-star due to various influencing factors and argues that current economic conditions do not definitively indicate a higher neutral rate. Waller highlights that despite economic resilience, there is no substantial evidence to support a significant rise in r-star at this time.
Williams focused on the broad context in which r-star should be considered, noting that factors like global financial conditions and demographic changes play a critical role. He cautioned against overestimating r-star based on short-term economic performance. Waller, echoing this sentiment, reiterated that while fiscal policies and global demand for safe assets are important, there is no clear indication that r-star has risen significantly.
Former New York Fed President William Dudley has been the clearest on this issue. As a former official, he has more leeway to speak openly about the potential for a higher r-star. Dudley highlights the strength of the U.S. economy and increased capital expenditures as significant factors pushing up the neutral rate. He notes that various factors, such as high stock prices and substantial government borrowing, reduce desired savings and increase desired investment, thereby raising r-star. Dudley’s analysis is crucial as it provides a candid perspective that current Fed officials might be more cautious to express.
Breitbart Business Digest warned about the possibility of a higher r-star back in February. In an article published on February 8, we cautioned that monetary policy might not be as restrictive as the Fed believed, due to the underestimation of r-star.
Stubborn Inflation, Softer Spending
April’s personal consumption expenditures (PCE) inflation data showed a modest rise of 0.3 percent month-over-month, with core inflation up 0.2 percent. While these figures align with expectations, they underscore the ongoing struggle to make significant progress in reducing inflation, which has been stuck at 2.8 percent year-over-year for three consecutive months. The slight increase in headline and core PCE suggests that inflationary pressures, while somewhat moderated, remain persistent.
Consumer spending also reflected a softening, increasing by just 0.2 percent month-over-month, the smallest rise in three months. This cooling, along with downward revisions to Q1 spending, raises concerns about the strength of the economic recovery. The weak spending data could weigh on second-quarter GDP growth, leading analysts to adjust their forecasts. Incomes rose by 0.3 percent in April, but this was not enough to significantly outpace inflation and provide relief to households.
Bank of America’s latest report echoes these concerns, noting that the small step in the right direction for inflation is not enough to alter the overall narrative. Revisions to core PCE inflation in Q1 were modest, with minor adjustments to January and March data. Despite some improvements, inflation accelerated at the start of the year, and progress has since stalled. The report also highlighted that personal spending increased by just 0.2 percent in April, with real spending dropping by 0.1 percent. This trend, coupled with a weak performance in goods and services spending, underscores the fragile state of consumer demand.
The Fed Is Stuck Because Inflation Is Stuck
The mixed signals from today’s reports and the ongoing debate around r-star suggest that the Fed faces a challenging path ahead. While some argue for more aggressive rate hikes to address potentially higher r-star and persistent inflation, others caution against overreacting to uncertain estimates.
The balance of evidence appears to support Logan’s and Kashkari’s perspective that r-star may indeed be higher than the Fed currently estimates. The economy does not seem to have been significantly restricted by the current interest rates, indicating that monetary policy might not be as tight as intended. This implies that the Federal Reserve might need to adopt a more aggressive approach to ensure inflation is brought under control.
Governor Waller emphasized the importance of monitoring fiscal policies and global economic conditions that could influence r-star. He warned that unsustainable fiscal spending could put upward pressure on the neutral rate, potentially complicating the Fed’s efforts to manage inflation. Similarly, Logan highlighted the need for the Fed to remain adaptable, ready to adjust its policy stance as new data emerge.
The debate around r-star is not just an academic exercise; it has real implications for the Federal Reserve’s policy and the broader economy. The persistent inflation and mixed economic signals indicate that the current monetary policy may not be restrictive enough. If that view wins over more officials at the Fed, it could mean that the Fed’s next move will be to increase interest rates rather than lower them.
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