Neutral Interest Rate (R-Star)
The Neutral Interest Rate, commonly denoted R-Star (r*), is the theoretical real short-term interest rate at which monetary policy is neither stimulating nor restraining economic growth, consistent with the economy operating at full employment and inflation at target.
R-Star is an unobservable variable — it cannot be measured directly and must be estimated through economic models. The most influential estimates are produced by economists at the Federal Reserve Bank of New York using the Laubach-Williams model, which infers r* from observed relationships between GDP growth, inflation, and short-term interest rates over time.
The concept matters enormously for monetary policy because the neutral rate defines the threshold between accommodative and restrictive policy. If the real fed funds rate is below r*, policy is providing net stimulus to the economy; above r*, policy is applying net restraint. Getting to r* is the central bank's idea of parking in neutral. But since r* is unknown and shifts over time, the Fed must make judgment calls about where the neutral rate currently stands when calibrating policy.
After the 2008 financial crisis, empirical estimates of r* in the US fell sharply — some models put it as low as 0.5% in real terms. The decline was attributed to slower trend productivity growth, an aging demographic profile that raises desired saving, and global capital flows seeking safe assets. This low r* environment meant that even very low nominal interest rates were not providing much accommodation once inflation was accounted for.
Post-pandemic, debate has intensified over whether r* has risen. Arguments for a higher r* include massive fiscal deficits that absorb global savings, the investment demands of the energy transition and defense spending, and a reversal of some globalization tailwinds that had kept prices down. If r* has structurally risen, the Fed may need to maintain higher nominal rates than in the 2010s to achieve the same policy stance.
For equity investors, r* matters because it anchors long-run discount rates. If r* has moved higher, valuations justified by a near-zero discount rate environment need reassessment. The equity risk premium — the excess return demanded over the risk-free rate — depends critically on where the real rate settles in the long run.