Many people in CRE want interest rates to return to their low pre-pandemic levels. That might be sustainable, or it might not be. The answer likely depends on an economic concept called R-Star. But it’s tricky, not something that can be directly observed, and a value that experts disagree over.
R-Star — also called the neutral or natural interest rate — is the short-term interest rate that enables full employment and maximum output with stable inflation. Note two things.
One, full employment doesn’t mean zero unemployment. Rather, it is the maximum number of people employed to create the goods and services that match demand using the necessary resources.
Two, stable inflation doesn’t mean zero inflation. It means prices rise in concert with demand and available resources to satisfy demand without waste.
R-Star cannot be observed in the world. Instead, it’s a shifting figure, like a spirit that moves this way and that, affecting the economy of nations and the globe without ever being caught in the act. The higher the value of R-Star, the more expensive financing becomes. Similarly, the lower the R-Star, the less expensive financing.
While the rate cannot be seen, it can be estimated and that is where disagreement and even confusion come in. The Federal Reserve Bank of New York notes multiple mathematical models to form an estimation. “The Laubach-Williams (2003) model uses data on real GDP, inflation, and the federal funds rate to extract trends in U.S. economic growth and other factors influencing the natural rate of interest,” they wrote. “The Holston-Laubach-Williams (2017) model extends this analysis to other advanced economies, estimating r-star and related variables for the United States, Canada, and the Euro Area. The Holston-Laubach-Williams (2023) model accounts for time-varying volatility and incorporates a persistent supply shock during the COVID‑19 pandemic.”
The Fed operates under the belief that R-Star is well under 1.0%.
“New York Fed President John Williams, a leading figure in the formulation of the R-Star concept, agrees that R-Star is not particularly useful in making near-term tactical decisions about rates,” Reuters reported. “But late last month he told reporters ‘the factors that have held down interest rates over the last decade or so, I think are still in play.’”
If he is correct, there might be room for longer-term lower rates. And yet, the economy hasn’t slowed as much as economists expected with the increased interest rates and there are questions of whether rates are high enough to bring inflation back to the Fed’s 2% target.
However, not all experts agree that R-Star is at the level the Fed assumes. “Using data from 1940 through 2022, we show that R-star has risen approximately 100 bps since the Great Recession, to 1.5% today,” research from Vanguard says. “We attribute this rise to changes in factors unrelated to long-run trend growth. In our econometric analysis, we explore potential effects from demographics and structural U.S. fiscal deficits and find suggestive evidence that deficits have contributed to the recent, notable rise in R-star.”
Who is right? It’s next to impossible to tell at the moment, which is one reason why economists don’t try to model monetary policy based on R-Star.