The headline of this fascinating JPMorgan report is so good that we’re appropriating it for our write-up.
R* is economics jargon for a natural or “neutral” interest that neither fuels nor slows inflation economic growth. The R stands for interest rates in economic equations, and the star represents its long-term nature.
Aside from lending itself to puns (the fault in R*, falling R*, twinkle twinkle little R* you get the drift) it’s a pretty important theoretical concept. The view that R* was close to zero in real, inflation-adjusted terms was one of the main drivers behind central banks pushing rates to zero — and below, in some cases — over the past decade.
It is even more important right now, when many central banks have jacked up rates to contain inflation, but are facing an increasingly tricky balancing act between tightening policy without causing economic calamity. But is R* actually still close to zero?
In a report published earlier this week, JPMorgan’s chief economist Bruce Kasman argued that it may now be creeping higher. That would mean interest rates will have to stay higher for longer than many people expect.
A year ago, we argued it was inappropriate to accept the widely held view expressed by central banks that the inflation process would remained anchored by the credibility of their medium-term commitments. Confidence in the inflation process did indeed erode in the face of a broadening inflation surge last year, despite well anchored medium-term expectations. This erosion in faith helps explain the dramatic acceleration in the pace of policy tightening.
We believe faith in another pillar underlying central bank thinking is on track to erode this year: the notion that DM neutral real policy rates stand close to zero. Identifying a “neutral” rate is important as central banks consider how far they continue in the policy adjustment process currently underway. DM central banks appear to be looking for a position whereby holding policy rates at an appropriate level above neutral — a high-for-long stance — can be anticipated to gradually ease labor market tightness and lower inflation.
Here is JPMorgan’s chart of its estimates for various neutral rates at the moment. Remember that these are real R-stars, ie after inflation.
Kasman argues that a “high-for-long strategy” is now necessary because of disappointing economic results of the “low-for-long” post-financial crisis approach. It’s like the pandemic and the stimulus unleashed to combat its economic impact were a defibrillator shock to the economic system.
We attribute the ineffectiveness of last decade’s low-for-long stances to powerful disinflationary forces unleashed by the GFC outside the control of central banks. Importantly, conditions have changed dramatically. In contrast to last decade’s post-GFC balance sheet adjustment and regulatory tightening, the pandemic and has improved private sector balance sheets and created pent-up demand. In addition, fiscal policy shocks during this cycle have generally been positive thus far, a radically different backdrop to the aggressive European and US tightening through the first half of the last expansion. Finally, the supply shocks related to the pandemic have altered the inflation process in a way that is likely raising short-term inflation risk premia. In all, these developments suggest that neutral policy rates have moved higher from estimates at the end of the last expansion.
Of course, as Kasman points out, central banks in the developed world have on average jacked up interest rates by 400 basis points over the past year, the most aggressive increase in over four decades.
Whether it will be enough, just right, or too much is still unclear. Like many economic concepts, even R*’s historical values are inherently uncertain. And the actual current level of R* “will be obscured for some time”, as Kasman puts it.
But the surprising economic resilience we’ve seen lately is a good indicator that R* is indeed higher than many economists thought just a year ago. That has big implications for monetary policy in the coming years.
