Navigating With The R Star

“It’s difficult to make predictions, especially about the future.” – Niels Bohr

On November 28, 2018, Federal Reserve (Fed) Chairman Jerome Powell gave a speech at the Economics Club of New York that sent the stock market soaring by over 2%. The reason cited by market pundits was the reversal of language he used a few weeks earlier suggesting that the Fed still had several more rate hikes ahead. In other words, he softened that tone and seemed to imply that the Fed was close to pausing.

By most accounts, Fed policy remains very accommodative but the “Powell Pivot”, which began in late November and continues to this day, hinges on an obscure metric called R-Star (r*).  Even though interest rates have been held low and vast amounts of liquidity force fed into markets through quantitative easing, the idea that interest rates should not rise much further presents a unique dilemma for the Fed. Rationalizations for their guidance hinges on r*. Before going into details about this important measure, let us reflect on history.

Doomed To Repeat It

“Well, we currently see the economy as continuing to grow, but growing at a relatively slow pace, particularly in the first half of this year. As the housing contraction begins to wane, as it should sometime during this fiscal year, the economy should pick up a bit later in the year. –Federal Reserve Chairman Ben Bernanke on January 17, 2008, in response to Congressman John Spratt ranking member of the House Budget Committee

The table below was a document used on an unscheduled Fed conference call on January 9, 2008, to discuss deteriorating credit conditions in the U.S. economy. At that time and unbeknownst to the Fed, the economy slipped into recession the prior month, yet the Fed’s commentary and one- and two-year outlook for growth remained positive. The point is not to deride Bernanke and the Fed but show that even the most well-informed Ph.D. economists struggle to forecast economic activity or assess current economic conditions properly.

(Click on image to enlarge)

The challenge in assessing the outlook for a highly complex system like the U.S. economy cannot be overstated. Yet, what we saw in the past and still see currently, is a small group of people with enormous influence over the economy failing to grasp the natural mechanisms of a market economy. To put it another way, the Fed continues to believe that they know things they simply cannot know, and most concerningly, they set monetary policy on the basis of that fallacy.

An Abstract Barometer

Over the past several years, Fed economists invented a concept that purportedly identifies the point at which monetary policy is “neutral” or in equilibrium with economic activity. This number, called r* (r-star), is abstract and imprecise as it requires a variety of assumptions about the level of interest rates and economic activity. R* is formally defined as the “inflation-adjusted, short-term interest rate that is consistent with the full use of economic resources and steady inflation at or near the Fed’s target level.

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Gary Anderson 10 months ago Contributor's comment

Interesting article. The Fed did not know what it was doing in 2007-2008, as inflation was still strong as recession took hold. NGDP was falling like a rock. Libor was inverted with the Swap rate. Those things took banks to the end of their rope. Does the Fed know what it is doing now? Who knows?

Duke Peters 10 months ago Member's comment

When has it ever known?