R-star and predictions that inflation and rates will fall to pre-pandemic levels

For over 20 years, Williams and company have been estimating the long-run neutral (or natural) rate — known to economists as r-star.

 This is the interest rate at which the economy is humming along at its potential, with full employment and inflation at 2 per cent. R-star is a guiding light for central banks. 

Interest rates above it mean the monetary policy stance is restrictive, and below it, accommodative.

When they re-ran their new, improved models, they determined R-star had barely budged despite everything. 

 If R-star is as low as it was pre-pandemic, then we can expect inflation and rates to fall again once the dust has settled on all the successive shocks.

However, the problem with using R-star as a guiding light is that it is a concept, not something that can be observed.

Furthermore, this tightening cycle hasn’t had the predicted impact on real economies. Another explanation is that R-star has in fact risen and the monetary policy stance isn’t as tight as central bankers think.

It would be a mistake for central bankers to take comfort in the notion that inflation and rates will automatically go back to the low levels we saw before the pandemic. 

Megan Greene FT 3 July 2023

https://www.ft.com/content/c25c999f-2e15-4644-a822-aab4eae429be

What central banks can do is to set a policy rate that is comparable with what the Swedish economist Knut Wicksell called a natural interest rate, R*.

Tlhe Market Monetarist 30 January  2023

https://englundmacro.blogspot.com/2023/01/re-visiting-r.html

Another relevant economics paper is Akinci et al. on “the financial stability interest rate”

 (which they call r**, not to be confused with r*, the neutral interest rate) — the threshold interest rate above which the central bank triggers a problem of financial stability.

“Persistently low real rates induce an increase in financial vulnerabilities and a consequent decline in the level of r**,” the authors write.

Niall Ferguson Bloomberg 18 december 2022 

https://englundmacro.blogspot.com/2022/12/the-threshold-interest-rate-above-which.html