August 23rd, 2023

Where is R-star headed amid climate change and higher inflation?

In Short

R-star or the real natural (or neutral) rate of interest is an important reference point for central banks, investors, and economic stability. Economically, it is the real interest rate (i.e. after subtracting inflation) that would prevail if the economy were in equilibrium. This demands price stability, a closed output gap, and full employment. This is a very comprehensive concept as changes by any fundamental imply a change in the real interest rate.

Highlights:

R-star or the equilibrium real natural rate of interest serves as a benchmark for monetary policy and investors. Fundamental developments such as climate change and the return of inflation may well move R-star to new values.
While conceptually straightforward, R-star is not directly observable and has been interpreted differently in terms of maturity (short-term vs long-term), asset class (risk-free vs risky), and estimation methodology.
Against this backdrop, empirical estimates of R-star are subject to high uncertainty and vary considerably within and across model classes.
To gauge the future direction of R-star, we show that the commonly used short-term estimates by Holston, Laubach and Williams (HLW) can be inferred from not only traditional real variables – like potential growth and the savings/investment balance – but also from inflation expectations and monetary policy variables in the US and euro area.
Our findings suggest that R-star cannot be treated as fully exogenous by monetary policymakers. The upward effects from higher inflation expectations vs post-GFC nadir in the euro area and the shift towards monetary policy tightening will more than offset the dampening effects from falling potential growth, while the effects of climate change on R-star are likely to remain small. As of late, R-star rose in the euro area but fell in the US. On balance, we expect R-star to inch up only marginally from current levels to about 1% in the euro area and rise somewhat more visibly to 0.9% in the US by 2030.
R-star is a major driver for government bond yields in the medium term. We find that apart from other fundamental factors like the term premium and future key rates especially the forecast increase in R-star will lift 10-year government equilibrium bond yields to 2.3% in the euro area and 2.9% in the US.

The outlook becomes more uncertain when considering financial stability issues. Latest research suggests that taking financial stability into account lowers R-star in case of high bank leverage. Hence R-star might in the future lose importance for central banks or be altered by financial stability variables.