What is the neutral rate (r-star)?

The neutral rate of interest, commonly referred to as r-star (r*), is the real short-term interest rate that is consistent with the economy operating at full employment and stable inflation. It is the rate at which monetary policy is neither expansionary nor contractionary. When the real federal funds rate is above r-star, policy is restrictive. When it is below r-star, policy is accommodative.

The problem with r-star is that it cannot be directly observed; it must be estimated from models. The most widely cited estimate comes from the Laubach-Williams model, maintained by the Federal Reserve Bank of New York, which uses a Kalman filter to extract the unobservable neutral rate from GDP and inflation data. Other estimates come from the Holston-Laubach-Williams model and the Lubik-Matthes model at the Richmond Fed. These models often disagree substantially, with estimates ranging from below 1% to above 2% in recent years.

R-star declined steadily from the 1980s through the 2010s, driven by demographic shifts (aging populations saving more), productivity slowdowns, rising inequality (wealthy households saving more), and increased global demand for safe assets. By the late 2010s, many estimates placed r-star near 0.5%, meaning the Fed only needed to set the real funds rate above 0.5% to be restrictive. This low r-star created the zero-lower-bound trap where the Fed ran out of room to cut rates in recessions.

The post-COVID debate centers on whether r-star has risen. Higher government deficits, reshoring investment, AI-driven capital spending, and deglobalization could all push r-star higher. If r-star has genuinely moved from 0.5% to 1.5%, it means the Fed can maintain a higher terminal rate without being overly restrictive, fundamentally changing the level at which rates "settle." The FOMC's longer-run dot, its collective estimate of the appropriate terminal rate, is the committee's implicit r-star signal and has been gradually revised upward since 2023.