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What Is R-Star (r)?*

• R-star (r*, the real neutral rate of interest) is a theoretical rate that allows an economy to grow at its potential without causing inflationary or deflationary pressures.

• It represents a "neutral" level where monetary policy neither stimulates nor restricts economic activity.

• R-star is a real interest rate, meaning it accounts for expected inflation.

Why R-Star Matters

• Monetary Policy Benchmark: If the policy rate is above r*, monetary policy is restrictive; if it is below r*, it is expansionary.

• Long-term Guidance: Central banks use r* to gauge where interest rates should stabilize in the future.

• Asset Valuation: R-star influences discount rates used in financial models, affecting corporate valuations and asset prices.

Challenges in Measuring R-Star

Unobservable Variable:

• R-star is a theoretical construct and cannot be directly observed.

• It must be estimated using economic models, which yield different results based on assumptions.

Structural Economic Changes:

• Technological progress, demographic shifts, and globalization impact r*, making its estimation highly uncertain.

Data Limitations:

• Economic data reflects past conditions, making forward-looking estimates difficult.

Different Models for Estimating R-Star

HLW Model (Holston-Laubach-Williams):

• Uses inflation and unemployment trends to estimate r*.

• Becomes unreliable when Phillips Curve relationships weaken.

UMod Model:

• Enhances HLW by incorporating labor market variables.

• Still constrained by data limitations and model complexity.

Simplified Approaches:

• Directly estimate output gaps.

• Reduce complexity but rely heavily on subjective judgment.

Policy Implications

• Over-reliance on r estimates can misguide policy decisions.*

• Central banks should use r as a flexible reference rather than an absolute target.*

• Considering multiple indicators (inflation expectations, labor market conditions, financial stability risks) is crucial for effective policy.

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