ROI-As Fed meets, elusive r-star still packs a punch: Mike Dolan

By Mike Dolan

LONDON, Dec 8 (Reuters) - If we don't know where interest rates should be in an ideal world, how can we judge what today's borrowing costs are doing to a hyper-complex economy? That's at the heart of the problem facing the Federal Reserve this week and throughout 2026 - and opinions have rarely been more divided.

For many investors, the search for a neutral interest rate is merely an academic parlor game, doomed to disagreement and theoretical ifs and buts.

Yet the concept of the so-called r-star still packs a punch because it defines the way central bankers still think - and how they decide whether policy is bearing down on economic activity or actively stimulating it.

Even if you stifle a yawn at the endless modeling of the notional r-star, you can't ignore that whatever the Fed or any other central bank assumes to be the neutral rate will influence what it does with the actual cost of money.

There's little argument about the past 40 years. U.S. r-star - R* - the inflation-adjusted neutral rate that balances savings and investment over time - fell relentlessly to within a whisker of zero from as high as 5% in the 1970s.

Ageing demographics and slower growth in major economies and a buildup of reserve piles in fast-growing developing nations, exaggerated by the 2008 banking crash, saw a savings glut that drove down the neutral rate. To spur credit growth and prevent deflation from taking hold in rich countries, central banks floored interest rates commensurately.

One obvious offshoot was that governments jumped on cheaper borrowing to build ever larger debt piles.

But that rising supply of bonds and "assets" then met a pandemic shock and subsequent inflation spike, all alongside a geopolitical rethink, world trade disruption, and critical demographic junctures as the baby-boom generation retires.

For many, that means r-star may well be heading higher again. And if that's correct and central banks stick with a "business-as-usual" view of the mega trends, they may underestimate how much fuel they are currently adding to the financial system and the wider economy at a time of seismic change.

SIMULTANEOUS SHOCKS

To the extent that 10-year inflation-adjusted Treasury yields track r-star developments, they fell from 4.4% in 2000 into negative territory by 2012 and relapsed again as the pandemic hit - averaging 1.6% over that 20-year span. But since the COVID-19 shock they have climbed back close to 2%.

A recent paper by former Bank of England economist Lukasz Rachel, now at University College London, reckons the five-point drop in r-star over half a century coincided with a near-doubling of wealth-to-GDP ratio in advanced economies.

He estimates the neutral rate now sits somewhere between zero and 1.2%, and a business-as-usual outlook could even see it drift lower in years to come.

But the Brookings paper breaks down the drivers and adds different scenarios - including an artificial intelligence transformation, re-militarization, de-globalization and other breaks with recent decades.

If any one of those trends were to be added, Rachel estimates, it would push r-star above 1%. If they all hit simultaneously, it could be as high as 3% going forward.

Even assuming central banks meet 2% inflation targets, that worst-case could put a neutral policy rate at 5% - which is also, curiously, where famed short-seller Michael Burry reckons it may be, according to a rare interview this week with author Michael Lewis.

SPLIT FED

So where does that all leave a Fed that is deeply divided on the issue at its latest meeting this week?

President Donald Trump's recent appointee to the Fed board, Stephen Miran, claims changes in immigration, tax and regulatory policies mean r-star is still falling and policy rates need to get far lower just to get to neutral.

New York Fed boss John Williams' recent indication that another rate cut was warranted seemed to cement market hopes of a cut this week, as he justified that view by saying current rates of 3.75-4.0% are still mildly restrictive.

Williams' own co-authored models of r-star put it at 0.9-1.4% - which might suggest a neutral policy rate is at least half a point lower from here if you add the 2% inflation rate.

This week the Fed also updates its quarterly projections - within which policymakers' estimates of a "longer-run" policy rate are seen as their best guess at neutral.

In September, the median of those views put it at 3% - a half point above where they saw it pre-pandemic, but with a range from 2.6% to 3.9%. So at least two Fed officials three months ago felt rates are now at neutral, while three thought the Fed was some 150 basis points above it.

Another cut may be coming this week, but shifts in this long-run view may color how markets read the way forward.

Wherever neutral really lies, many market economists - watching loosening financial conditions and an investment boom, near 4% annualized growth estimates and inflation almost a point above target - think further significant Fed cuts from here may well overheat the economy next year.

If we only knew where elusive r-star was, the guessing game would be a lot easier.

The opinions expressed here are those of the author, a columnist for Reuters

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(by Mike Dolan; Editing by Marguerita Choy)