By Jon Faust and Robert Barbera

Given the focus on the neutral real interest rate, r*, at the last several FOMC press conferences, one might be forgiven for thinking that estimates of r* play an important role in policymaker judgments about the restrictiveness of monetary policy.  We think this gets things backwards.

In much conventional thinking, r* would be key to assessing restrictiveness:  The further above r* is the current real federal funds rate, the more restrictive is policy.  

But the value of r* is both changeable and highly uncertain.  In real time, the only reliable indicator of r* is how restrictive monetary policy appears to be.  How strong is growth? What is happening to inflation? In short, judgements about how restrictive policy is affect views of r* much more than the other way around.  As Chair Powell of the Fed is fond of putting it, we know r* “by its works.”

Admittedly, there are various estimates of r* based on longer-run factors, rather than assessments of current conditions.  Given the estimates right now, policy is anywhere between roughly neutral and very restrictive.   The range of r* estimates implied by FOMC participants’ recent projections is nearly as large.

Moreover, longer-run r*, the quantity implied by the FOMC projections, is of limited value in judging the current stance of policy.  Ever present headwinds and tailwinds (not to mention crosswinds) strongly affect how restrictive any given setting of the federal funds rate is, at any given moment. 

Reflect upon the most recent tightening cycle. The fed funds rate was lifted by more than 500 basis points, a move that would be expected to put major stress on corporations. But the fantastic monetary and fiscal support offered up during COVID had allowed businesses to build up cash reserves and lock in long-term loans at super low interest rates. Quite improbably, as the Fed took short rates sharply higher, the large cash hoards delivered interest income that, in aggregate, more than matched the rise in interest expense. This blunted the cash squeeze that normally accompanies sharp rate increases and likely moderated the restraining effects of the rate rise.

Similarly, as 2019 began, with inflation near 2 percent, growth exceeding potential, and unemployment below most estimates of its natural rate, standard thinking about r* called for rate increases.  Instead, the FOMC cut rates by 75 basis points over the year.  While the economy remained strong, short-run r* arguably fell due to what the FOMC referred to as “crosswinds” of slower global growth and concerns over a possible tariff-induced trade war.  How the economy will react to trade risks this time around is very much in question. 

Overall, while the concept of r* plays an important role in organizing thinking about the restrictiveness of policy, when it comes to practical judgments, we agree with Chair Powell: “r*…doesn’t really get you where you need to be to think about what appropriate policy is in the near term.”