The Neutral Rate (r-star)
What Is The Neutral Rate (r-star)?
The neutral rate, often written as r-star (r*), is the level of interest rates that is understood to neither stimulate nor restrict economic growth. At the neutral rate, monetary policy is neither expansionary nor contractionary; the economy runs at a sustainable pace with stable inflation. When the Fed sets its policy rate below neutral, policy is generally stimulative; when it sets the rate above neutral, policy is generally restrictive. The neutral rate is not directly observable and cannot be measured precisely - it is estimated from economic models and shifts over time with factors like productivity growth, demographics, and savings patterns.
Why It Matters
The neutral rate matters because it is the invisible dividing line the FOMC is implicitly aiming at whenever it decides whether policy is "tight" or "loose." A rate that sounds high in absolute terms might still be stimulative if the neutral rate has risen, and a seemingly low rate might be restrictive if neutral has fallen. That is why estimates of r-star feature heavily in Fed debates and in the longer-run projections shown in the dot plot. Because it can only be estimated, the neutral rate is a source of genuine uncertainty: policymakers are steering toward a target they cannot see directly, which is part of what makes calibrating monetary policy so difficult.