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Federal Reserve
Why R-star may rise, and its implications for rates and policy
Jared Franz

R-star is the real interest rate that is neither expansionary nor contractionary when the economy is at full employment. If the central bank sets its policy rate below R-star, then its monetary policy position is accommodative. The Fed currently believes R-star is about 0.5%, which is significantly lower than the Fed’s calculation of 2% a decade ago.

However, several factors are driving up this R-star value:

1. Demographic dynamics may be changing - the US and other developed nations are shifting from aging populations to old populations. As people age, they eventually save less, which is supportive of a higher R-star.

2. Government spending is expected to increase - a general rule of thumb is that a percentage point increase in federal debt to gross domestic product (GDP) can help push up R-star by three basis points. Over the past decade, US government debt held by the public has grown from 70% of GDP in 2012 to 97% in 2022, equating roughly to an 80 basis point increase in R-star.

3. Capital investment in factories, warehouses and supply chains will likely rise - The pandemic, US-China tensions and the Russia-Ukraine war have put a new emphasis on building reliable supply chains and ensuring national self-sufficiency. Companies are looking to shift operations closer to end markets or add redundancy. This could unleash a new wave of capital investment in physical infrastructure which should lead to a net upward pressure on real interest rates.

4. A productivity boost may be coming - the rise of generative AI such as ChatGPT may help lead to a recovery in labour productivity, which could also motivate corporate investment. And every dollar of investment would contribute to a higher R-star.

Jared Franz is an economist with 18 years of investment industry experience. He holds a PhD in economics from the University of Illinois at Chicago, a bachelor’s degree in mathematics from Northwestern University and attended the U.S. Naval Academy. 

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