Understand r-star if you want to understand the Fed

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

The results show that r-star is currently negative and heading lower. This means that current nominal rates minus inflation may actually be less accommodative than thought. Inflation has to pushed higher to generate a real rate that will get us to full employment. The devil is in the details, but the changes in model assumptions and structuring will get different results. It suggests that r-star guide may be suggestive but not a helpful guide for policy.

Still, following r-star can help asset manager as a measure where rates should be over the longer-run. All r-star models show that the equilibrium real rate should be lower today than over the last few decades. There is nothing that will suggest rates should be headed higher or that the Fed will take action that will offset current accommodations. The Fed has given forward guidance, but r-star provides empirical evidence that rates will stay low. As a blunt instrument, r-star can still be helpful.