R-Star (Natural Rate of Interest)

What Is R-Star?

R-star (r)*, also called the natural rate of interest, is the theoretical real short-term interest rate consistent with output at potential and inflation at target. It is the anchor point that monetary policy is measured against: if the actual real interest rate is above r-star, policy is restrictive; below r-star, policy is accommodative.

R-star is unobservable. It must be inferred from structural models of the economy. The Federal Reserve Bank of New York publishes two of the most widely cited estimates: the Laubach-Williams (LW) and Holston-Laubach-Williams (HLW) models. The Fed staff also uses internal r-star estimates that are not publicly disclosed.

Why It Matters for Markets

R-star is the single most important number Fed officials cite when defending the policy path. The dot plot's "longer run" median represents the FOMC's consensus view of where the funds rate will eventually settle — implicitly r-star plus 2% inflation target. The longer-run dot at 3.0% (as in late 2024) implies an r-star estimate of approximately 1.0%.

Markets that watch r-star understand the policy path better than markets that don't. A 25 bp upward revision to the longer-run dot signals a structural shift in policy thinking, often producing 30-50 bp moves in the entire back end of the Treasury curve.

How to Read the Print

Multiple model comparison. LW, HLW, and other estimates produce different numbers. The Fed staff typically considers a range rather than a point estimate. A consensus near 1.0% in late 2024-2025 reflects the convergence of multiple models post-pandemic.

Real funds rate vs r-star gap. The real funds rate is the nominal funds rate minus inflation expectations. When the gap (real funds minus r-star) is positive, policy is restrictive. The post-2024 Fed cuts narrowed this gap from approximately +200 bp at the 2023 peak to roughly +75 bp by mid-2025.

Longer-run dot in the SEP. The FOMC's median longer-run dot is the closest available proxy for the committee's r-star consensus. Changes in the longer-run dot are major regime signals.

Historical Context

R-star averaged approximately 3% in the 1960s-1970s and 2-3% in the 1980s-1990s. The decline through the 2010s reflected demographic shifts (aging populations save more), the global savings glut, and post-GFC deleveraging. By 2020 most estimates put r-star near 0.5%.

The post-pandemic re-acceleration has pushed estimates higher. The HLW model put r-star at approximately 0.7% in early 2024 and around 1.0% by mid-2025. The structural debate over whether r-star has permanently risen (productivity, fiscal dominance) versus temporarily risen (post-pandemic dynamics that will fade) is one of the most important macro questions of the cycle.