r* is the real short-term interest rate consistent with output at potential and stable inflation — the rate at which monetary policy neither stimulates nor restrains the economy. It is unobservable, must be estimated, and anchors how restrictive any given policy stance actually is.
How it works
r* is the equilibrium real rate at which saving equals investment with output at potential. Policy stance is gauged by the gap between the prevailing real rate and r*: a real rate above r* is restrictive, below it accommodative. Because r* is unobservable, it is inferred from models like Holston-Laubach-Williams that filter it out of growth, inflation, and rate data.
Why it matters now
The post-2022 debate over whether r* has drifted structurally higher — driven by fiscal deficits, defense and AI capex, and reshoring — directly determines how restrictive the Fed's current stance really is and how far it can cut before reaching neutral.
Example
In the FOMC's September 2024 and 2025 projections, the longer-run dot drifted up toward roughly 3.0% nominal — implying a real r* near 1%. But several estimates and market commentators argued the short-run real natural rate had risen to around 2.6% in 2025, meaning a 4.25-4.50% policy rate against ~2.5% inflation left real rates only modestly above r* — far less restrictive than headline levels suggested.
Frequently asked
- What is r* (the natural rate of interest)?
- r* is the real short-term interest rate consistent with full employment and stable inflation — the rate at which monetary policy is neither expansionary nor contractionary. It is unobservable and must be estimated from data on growth, inflation, and interest rates. Estimates like the New York Fed's Holston-Laubach-Williams model are widely cited benchmarks.
- Why does r* matter for monetary policy?
- r* matters because it defines the dividing line between tight and loose policy. A policy rate above r* in real terms restrains the economy; below it stimulates. Without knowing r*, the FOMC cannot say how restrictive a given fed funds level truly is, which directly shapes how far rates can fall before reaching neutral.
- How is r* estimated if it cannot be observed?
- r* is estimated using statistical filters and structural models that infer it from observed growth, inflation, and real rates. The Laubach-Williams (2003) and Holston-Laubach-Williams (2017) models are the most cited, treating r* as a slow-moving latent variable tied to trend potential growth. Estimates carry
Glossary · carry
Carry is the income earned (or paid) for holding a position over time, independent of price change — the coupon, yield, or interest-rate differential captured while waiting. Positive carry pays you to hold; negative carry costs you. It is the return that accrues if nothing moves.
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- Has r* risen since the pandemic?
- Many economists argue r* has drifted higher since 2022, reversing the secular decline of the 2010s. Drivers cited include larger structural fiscal deficits, defense and AI-related capex, and reshoring investment. Some 2025 estimates put the short-run real natural rate near 2.6%, implying current policy is less restrictive than headline rate levels suggest.
- How does r* differ from the terminal rate?
- r* is a real equilibrium concept — the neutral rate over the medium run — while the terminal rate
Glossary · terminal rate
The terminal rate is the endpoint of a central bank's policy-rate path — the level at which the policy rate settles once a hiking or cutting cycle completes. Markets price it from the forward curve, and it anchors the front end of the yield curve and rate-cut expectations.
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