This article, “The Stars Our Destination: An Update for Our R* Model,” discusses the concept of the natural real rate of interest, known as r*, a crucial element in monetary policy decisions. The r* represents the equilibrium interest rate in a scenario where the economy is growing at its trend rate, inflation is stable, and there’s no excessive supply or demand. However, r* isn’t directly observable and must be estimated using economic models.
The authors, Thomas A. Lubik and Christian Matthes, address the difficulties faced in estimating r* during the pandemic, given the economic volatility and potential structural shifts in the economy. They focus on the Lubik-Matthes model for estimating r*, which faced challenges during the COVID-19 pandemic due to unprecedented economic conditions, leading to extremely volatile key economic indicators and potential long-term changes in economic structures. In response to the pandemic, the Federal Reserve reduced the policy rate, and a subsequent economic recovery led to heightened inflation, prompting a series of rapid rate increases starting in 2022. During this period, estimating r* was crucial for policy decisions.
However, traditional models, including the well-known Holston-Laubach-Williams model, struggled, leading to a divergence in r* estimates. The Lubik-Matthes model was modified to better reflect these economic shifts, adjusting its sensitivity to recent data and accounting for increased volatility. This process involved several tests and comparisons with real-time data, accounting for potential measurement errors often present in initial data releases. The authors found that their model’s standard specification might overestimate r* due to its sensitivity to volatility and data issues. They propose a revised model that restricts parameter variability, providing a more stable and reliable r* series.
The updated model indicates an increase in r* to 2.28 percent, adjusted for the unique economic circumstances of the time. This detailed analysis underscores the complexity of estimating r* in unprecedented economic conditions and highlights the need for adaptable economic models. The authors’ adjustments to the Lubik-Matthes model aim to provide more reliable guidance for monetary policy decisions in volatile environments. The views presented are those of the authors and do not necessarily represent those of the Federal Reserve Bank of Richmond or the Federal Reserve System.
Note:
The natural real rate of interest, often referred to as the neutral rate or
�∗r∗ (r-star), is a concept used in macroeconomics to describe the theoretical rate of interest at which the economy is in a neutral state—meaning the economy is operating at full capacity, with full employment, and is neither expanding nor contracting. In other words, it’s the interest rate that prevails when the economy is at equilibrium, where inflation is stable and the economy is growing at its potential rate.
This rate is not directly observable, as it’s a theoretical construct that reflects underlying economic conditions, including time preferences for current versus future consumption, productivity growth, demographic trends, and other factors influencing investment and savings.
Source: The Stars Our Destination: An Update for Our R* Model | Richmond Fed
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