Assessing Fed policy: What is r*?

Jim O'SullivanR* is essentially the neutral rate for monetary policy, explains Jim O’Sullivan.  “Of course, there is no way to know precisely what that is, and it can change over time.”

Furthermore, there are times when the Fed needs rates to be below neutral (accommodative) and times when it needs rates to be above neutral (restrictive).

In March, the median Fed official projection for the longer-run normal funds rate rose to 2.9% from 2.8%.  That assumes the Fed’s 2% inflation goal is realized, which implies that a 0.9% real funds rate would be neutral.

The real funds rate is now 0.1% if one uses the current 1.5% year-over-year change in core PCE prices as the deflator.  The implication is that the real funds rate is currently 0.8 points below the long-run neutral—i.e., 0.1 versus 0.9.  In other words, monetary policy is still accommodative.

“Some monetary accommodation might be justified since inflation is still too low,” says O’Sullivan, “although that argument is increasingly debatable with the unemployment rate already below the estimated full-employment level.”

Fed officials have been arguing that the current r* is lower than the longer-run normal.  On that basis, policy may not be as accommodative as the 0.1 versus 0.9 comparison implies.

“I am a bit skeptical of that argument,” says O’Sullivan. “Plus, there is ongoing stimulus from QE’s stock effects, in addition to the low real funds rate.”

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