In his latest speech, New York Fed President John Williams discusses "R*" the neutral interest rate which is neither expansionary nor contractionary.

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Pre-pandemic estimate of R*, the neutral rate, from the New York Fed

Current View of R* From New York Fed

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Current estimate of R*, the neutral rate, from the New York Fed, Mish blue box highlight

The Future Fortunes of R-star: Are They Really Rising?

Let's flash back to a May 18, 2018 article by John Williams, then president of the San Francisco Fed. 

Please consider The Future Fortunes of R-star: Are They Really Rising? 

Emphasis is mine.

R-star and the new normal

So what is this r-star I keep referring to, and why is it so important when it comes to thinking about interest rates?

R-star is what economists call the natural rate of interest; it’s the real interest rate expected to prevail when the economy is at full strength. While a central bank like the Fed sets short-term interest rates, r-star is a result of longer-term economic factors beyond the influence of central banks and monetary policy.

Such is my fascination with interest rates, that r-star is an area I’ve researched extensively. If by the end of this speech you share just a tenth of my passion for r-star, I’ll feel like I’ve done my job!

My own view is that r-star today is around 0.5 percent. Assuming inflation is running at our goal of 2 percent, that means the typical, or normal short-term interest rate is 2.5 percent.

Bad Models, Bad Policies

If R* was 0.5 percent, then nominal short-term interest rates should have been 2.5 percent in 2020.

Yet, the Powell Fed slashed rates all the way to zero, hoping to spur inflation that was clearly soaring, yet the Fed did not see. 

Now, if R* is 0.5 percent the implied rate should be 2.5 percent. 

In 2018, Williams said, "Three key global developments have caused r-star to come down in a number of developed economies over the past two decades: changes in demographics, a slowdown in productivity growth, and heightened demand for safe assets."

Williams failed to mention fiscal policy and free money handouts. In 2020, the Fed clearly missed those items.

And currently, Williams misses de-globalization, decarbonization, and totally inept global policies all adding to inflation.

Where is R*, Is there Even an R*?

To answer the second question first, yes, there is an R*.

But only a free market can figure out where it is. So, despite Williams' study of R*, he has no idea where it is (nor does anyone else), because it is dependent on changing global factors beyond the Fed's control.

Thus, Williams has a problematic self-assessed "fascination" with R*, despite the obvious fact the Fed is clueless in what it is doing. 

R* Is Back!

Measuring Neutral Interest Rates 

R* Is Not Back!

R* isn't back, because it never went away. 

There is indeed a neutral rate, but the Fed has done a pathetic job finding it. 

Greg IP is certainly correct "John Williams' conclusion that the neutral rate is still low raises more questions than answers."

Fed Groupthink

The Fed will continue to miss finding R* because they have no idea the net impact of de-globalization, decarbonization, and demographics. 

The Fed claims to be data dependent but they stick to group-think models that do not work. 

There are simultaneous inflationary and deflationary forces right now. 

Inflation Take

• Demographics Part 1: The replacement of retirees and full-timers going to part timers with those less skilled is inflationary.
• Demographics Part 2: Expect huge increases in need for Medicare commodities and services.
• When the Fed cut rates to zero, existing homeowners could and most did refinance at or below 3 percent. This continually puts extra money in their pocket every month at the expense of Zoomers now looking for their first home.
• The SS COLA and 2023 tax adjustment support consumption at least for a while.
• Wage pressures due to minimum wage hikes perpetually raise worker demands for wage growth. And workers can get what they seek because of demographics.
• Biden's energy plan is hugely inflationary.
• Biden's push for more union jobs is inflationary.
• De-globalization, barely started is inflationary.
• Going from just-in-time manufacturing to better-be-safe supply chain management is inflationary.

Deflation Take

• Money supply is very deflationary.
• Rising interest rates are deflationary.
• Debt is very inflationary when you struggle to pay it back while asset prices fall.
• Unrealized bank losses curtail lending and that is deflationary.
• A stock market crash would be very deflationary.
• Rising unemployment would be deflationary.
• Demographics Part 3: Money is conserved in retirement especially if the stock market does not keep growing.
• Demographics Part 4: SS does not make up for loss of job income.
• There's even a deflation aspect to what Biden's attempting to do with energy. What happens if people refuse to buy EVs? 

Which View Has More Force?

We can realistically debate this but I sympathize with the view "There's nothing more deflationary than not having a paycheck....6 to 12 months out we're not going to need labor to fill orders we don't have." Then what?

Worst of Both Worlds, Stagflation Right Now, But What's Ahead?

On April 28, I posted Worst of Both Worlds, Stagflation Right Now, But What's Ahead?

There are huge inflationary and deflationary forces. 

No one knows what additional inflation-adding regulatory forces are on the way. But if by some miracle Congress actually lowers debt or raises taxes, add those things to the deflation side.

Meanwhile, Williams sits back and pontificates over R* and lets his assessment of what R* should be based on his perception of demographics, when in fact there are multiple demographic factors on both sides of the ledger.

R* did not go away, and neither did groupthink. 

The Fed cannot do anything about R* because it's beyond its control. 

Realistically, the Fed should abandon trying to figure out where R* is because their groupthink assessment will never get it right, amplifying policy errors in both directions along the way.

Regarding groupthink on inflation expectations and the Phillips Curve, please see Inflation Expectations are Crashing. So What? It Doesn't Matter.

Groupthink is alive and well, complete with nonsensical models.

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