The neutral rate aligns with stable price levels and maximum employment. If rates are higher than r*, it suggests a restrictive monetary environment leading to lower inflation. Conversely, rates below r* indicate higher inflation is likely. The ideal goal is to land the economy at the neutral rate, where savings and investments are balanced without causing inflation.
Despite its appeal, finding r* is challenging because it’s not directly observable. Central banks rely on models to estimate this rate, with the Federal Reserve using models like Laubach-Williams and Holston-Laubach-Williams. These models provide approximations but don’t reveal the true neutral rate.
Various factors drive r*, including potential economic growth, demographics, risk aversion, and fiscal policies. The trend of declining rates over the past forty years stems from forces like rising savings rates, globalization, and low productivity growth. Monetary policy also affects r*, with artificially low rates leading to economic imbalances like faulty investments, prolonged supply chains, and fiscal imprudence.
Looking ahead, factors like post-pandemic inflation, fiscal deficits, and shifts in financial globalization may lead to an increase in r* and a halt to the declining rate trend. Estimating r* remains challenging, as it varies across regions and may be influenced by bureaucratic decisions rather than individual choices.
In the quest for the elusive neutral rate of interest, ongoing research and evolving models will continue to play a crucial role in understanding and predicting the future trajectory of r*. As economic landscapes shift, the search for r* may lead to new insights and challenges, shaping the policies and decisions of central banks worldwide.