Financial markets have shifted their expectations of US interest rate cuts this year, with initial predictions of six quarter-point cuts by the end of 2024 now reduced to just one. There is even speculation that the next move might be an increase in interest rates. This uncertainty has left borrowing costs at the end of 2024 in a state of flux.
Economists are looking to R-star, or the neutral rate of interest, as a guide to where interest rates in the US and elsewhere are ultimately heading. R-star is the rate that balances desired savings and investment when output is at an economy’s potential and inflation is at target. While the median Fed official estimates R-star to be 2.6 percent, the question remains whether the committee can accurately predict this rate given the current economic conditions.
The decline in nominal and real interest rates over the years has been attributed to various factors such as inflation control, secular stagnation, and rising inequality. However, the recent rise in borrowing costs post-pandemic has complicated this narrative, leading to questions about whether R-star has also increased. The disagreement among economists and policymakers on the trajectory of R-star highlights the challenges in estimating this crucial economic indicator.
Overall, the uncertainty surrounding R-star and its implications for interest rates has left central bankers and markets in a state of flux. The reliance on market data and structural models to estimate R-star has only added to the complexity of the situation. As central banks grapple with these challenges, the need for a more nuanced approach to monetary policy becomes increasingly apparent.