The Fed has policy interest in r-star, the rate of interest that will occur when the economy is at full employment and the targeted inflation rate; however, it has solicited mixed reviews in Fed speeches given it is an unobservable number and subject to distortions when rates are low.
It makes perfect sense in theory to serve as a guide if the estimates are good, but that is a big if. If rates are higher than the appropriate r-star or neutral rate, monetary policy is not accommodative, and the Fed should use policy to lower rates. Similarly, if rates are below r-star, the Fed should tighten policy to offset the accommodative environment.
Currently, the two r-star models posted on the NY Fed website suggest that the equilibrium real short-term rate is below 50 bps. By this measure, Fed policy is accommodative but therein lies the problem with r-star as a policy tool. If r-star is not measured correctly, there is the potential for wrong-footed policies. The Fed may think it is accommodative, but in reality, it could be following a tight policy. The r-star models can tell us something about the neutral rate equilibrium but it should not tell anything about policy moves.
A new paper, "Estimates of r* Consistent with a Supply-Side Structure and a Monetary Policy Rule for the U.S. Economy", suggests that the problem of estimation error with r-star is real and should be a concern for policymakers interested in using it to guide monetary action. The paper makes enhancement to r-star through adjusting for the zero lower bound on rates and accounting for the relationship between rates and the IS curve. The lower bound problem can be addressed through forming shadow rates which can go negative. Changing the model generates significant differences in r-star estimates
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