Acknowledging Limits - Central banks' pursuit of policy purity with regard to R-Star.

Estimating the natural rate of interest rate, commonly known as the R-star (r*), involves various statistical methods, each leveraging different economic models and assumptions. There is the LW, HLW, LM, DSGE, and other models*, each of these methods has its pros and cons and its best to run several models simultaneously in order to arrive at a more accurate monetary policy trajectory. Estimating r*, is a theoretical pursuit and is not directly observable, it must be estimated using economic models and expert surveys, a process fraught with substantial uncertainty. Nevertheless this rate is pivotal for understanding economic equilibrium, influencing monetary policy, and guiding financial stability.

In his speech at the Reykjavik Economic Conference on May 24, 2024, Governor Christopher J. Waller of the Federal Reserve delved into the complex dynamics of the natural rate of interest, r*.

Historic Decline of the r-*

Over the past several decades, there has been a marked downward trend in the real yield on 10-year U.S. Treasury securities. This decline suggests a falling r*, contrasting with the relatively stable real return on capital. This divergence indicates that various factors have uniquely influenced the demand and supply for safe assets, such as U.S. Treasuries, compared to riskier investments like corporate bonds or equities.

Key Factors Influencing the Decline

1. Enhanced Safety and Liquidity: U.S. Treasuries have become increasingly sought after for their stability and liquidity, especially amid reduced U.S. inflation and economic volatility.
2. Global Capital Market Liberalization: The expansion of global financial markets has amplified demand for safe assets, notably U.S. Treasuries, driven by international investors seeking stability.
3. Rise in Official Reserves and Sovereign Wealth Funds: Foreign governments and sovereign wealth funds have significantly increased their holdings of U.S. debt, further boosting demand.
4. Demographic Shifts: An aging global population has intensified the preference for secure investments, contributing to the downward pressure on r*.
5. Post-Financial Crisis Regulations: Enhanced regulatory requirements post-2008 financial crisis have heightened the demand for liquid and safe assets, including U.S. Treasuries.

Prospects for r*

Waller points to several factors that could influence the future trajectory of r*:

• U.S. Fiscal Sustainability: The burgeoning federal debt may eventually surpass the global demand for U.S. Treasuries, potentially driving up r*. This is a point we have repeately made since July 2021, espeically given the geopolitical developments and trends.
• Demographic and Geopolitical Changes: Continued global aging and possible geopolitical shifts might alter the dynamics of demand and supply for safe assets, influencing r*. This is also a point we have made since July 2021.

The prolonged decline in the natural rate of interest has been driven by a confluence of factors. Governor Waller's insights highlight the intricate interplay of global economic forces shaping this critical benchmark. However we are convinced that recent trends suggest a potential increase for the natural rate of interest.

We believe that the natural rate of interest is higher than current estimates suggest. The significant factors that contributed to the decades-long decline in U.S. long rates were largely a function of a secular cycle that has now run its course. This has given way to a new secular cycle influenced by a multitude of factors, including demographic, social, geopolitical, and geoeconomic trends.

The natural rate of interest is higher; r* is out there somewhere, while its exact location remains elusive, we suggest looking towards the zenith, the highest part of the night sky, for guidance. Observing objects near the zenith is generally preferred because atmospheric distortions are minimal compared to the horizon, offering a clearer view—an apt metaphor for understanding the future trajectory of r* in our complex economic landscape.

We continue to look for a steady rise in the term premium, for all developed markets, towards much higher levels during this secular cycle, and as such we have positioned our model portfolio accordingly in August of 2023.

Central bankers need to acknowledge the limits of theoretical constructs and rely more on pure intuition, and contemplate more on the bigger broader underlying trends, secular trends.

Please don't hesitate to reach out if you'd like further insight into our perspective.

Chart: The Term Premium - From May 24, 2024 speech of Goveernor Waller, SomeThoughs on r*: Why Did It Fall and Will It Rise? - We expect the term premium to be north of 1% in this secular cycle.

Notes and Reference:

1. Laubach-Williams (LW) Model: Developed by Thomas Laubach and John Williams, this method uses a state-space model to jointly estimate the natural rate of interest, potential output, and the output gap. It employs the Kalman filter to handle the unobservable components and is widely used by central banks including the Federal Reserve Bank of New York​ (New York Fed)​​ (SF Fed)​.
2. Holston-Laubach-Williams (HLW) Model: An extension of the LW model, it includes additional countries to make it applicable internationally. This model incorporates measures of global economic conditions and uses Bayesian techniques to estimate r*​ (New York Fed)​.
3. Lubik-Matthes (LM) Model: This method, used by the Richmond Fed, offers a more flexible framework than the LW model. It uses Bayesian estimation techniques and incorporates a broader range of macroeconomic variables, such as GDP growth, inflation, and real interest rates, to estimate the natural rate of interest​ (Richmond Fed)​​ (Richmond Fed)​.
4. Dynamic Stochastic General Equilibrium (DSGE) Models: These models simulate how shocks to the economy influence variables over time. They include microeconomic foundations and are used by central banks to estimate the natural rate of interest as part of their broader economic modeling efforts​ (SF Fed)​.
5. Time-Varying Parameter Models: These models allow parameters such as the natural rate of interest to change over time in response to evolving economic conditions. This approach is useful for capturing long-term trends and structural changes in the economy​ (Richmond Fed)​.
6. Econometric Models with Structural Breaks: These models account for sudden changes in the economic environment, such as financial crises or major policy shifts. They adjust the estimation of r* to reflect these breaks, improving the accuracy of the estimates during periods of economic turbulence​ (SF Fed)​.
7. https://www.richmondfed.org/publications/research/econ_focus/2018/q4/federal_reserve
8. INTEREST AND PRICES (Geldzins und Guterpreise) A STUDY OF THE CAUSES REGULATING THE VALUE OF MONEY -By - KNUT WiCKSELL, 1936 MacMillan and co. https://archive.org/details/interestandprice033322mbp/page/n5/mode/2up - In this book by Knut Wicksell he introduces the concept of the "natural rate of interest," which represents the real rate that equilibrates saving and investment in an economy without inflationary or deflationary pressures.