An IMF Economist On The Challenge Of Finding The Neutral Rate Of Interest

Tracy Alloway (0:10)

Hello, and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway.

Joe Weisenthal (0:15)

And I'm Joe Weisenthal.

Tracy Alloway (0:18)

Joe, you know what question we keep asking, lately especially?

Joe Weisenthal (0:23)

Probably something about monetary policy and fiscal policy of the zero lower bound or whether it all works anymore and whether we have to rethink literally everything everyone has thought for decades.

Tracy Alloway (0:36)

Yeah, I think that's right. But I was thinking more specifically, we keep asking policy makers if they actually understand inflation. And I think that's something we asked Neil Kishkari very recently and we asked Vitor Constantio before that.

And I'm not entirely convinced that we do understand inflation. Clearly the fact that we have been missing the target for many, many years suggests that there is something that we are missing.

Joe Weisenthal (1:04)

I mean, it really is one of the sort of most profound questions.

And it was, we chatted several weeks ago with the ECB Vice President, our former ECB Vice President Vitor Constantio. And it's like, here's someone high up in the central bank. The central bank's mandate is to either target or control inflation. And yet there is a lot of doubt whether anyone actually has a sort of robust theory of what causes it. And that's like a pretty profound thing given how much is weighing on this measure or this concept.

Tracy Alloway (1:43)

Yeah, absolutely. And I got to say, the way policymakers think about inflation, there are a couple things or factors that come up a lot in their intellectual framework for thinking about this.

And that is, or are, that is our, that is our, it's our start. Sorry, I'm not making any sense. But those things are known as the stars. Do you know what I mean, Joe?

Joe Weisenthal (2:11)

I do. But why don't you like describe them? Because I bet you'll like describe the stars better. This idea that central bankers, policymakers have this idea of stars.

I'm kind of, I get it. But why don't you like sort of tell people what they are?

Tracy Alloway (2:26)

Let me just say, first of all, probably the best known star is our star or the neutral rate of interest, which is the place where monetary policy isn't easy or tight, it's just neutral. So the clue is in the name. But the stars in general are kind of, they kind of describe the longer term steady state of the economy. So there are things like the natural rate of unemployment, the neutral rate of interest, which I mentioned, the level of potential output, the growth rate of potential output, as well as the central bank's inflation target. And they're called stars because all of the variables are shown as a lowercase letter and a little star next to it. So R star, Y star, G star, things like that.

And they've sort of come into prominence in recent years. So Jerome Powell at his first speech at Jackson Hole when he became Fed Chairman gave a whole talk that was basically just about the R star. And I think the best way to think about them is probably that the stars are pieces of the missing inflation puzzle that we've been talking about. So if inflation isn't showing up like central banks think that it should, then it's possible that there's more slack in the economy than appreciated, or it's possible that monetary policy isn't actually as accommodative as central banks think it is.

And that's where the stars come in. Our assumptions of the stars of the natural state of the economy, the long-term natural state of the economy, aren't those correct?

Joe Weisenthal (4:05)

Right. I mean, by the way, people should really go read that Jackson Hole speech from Powell from 2018, because I think it was very great. It was really good. It sort of anticipated a lot of the discussions that have ensued since then.

This idea that tightness or heat in the markets doesn't necessarily show up at inflation like it once did, but showed up more in financial markets, financial instability. And then, but I think this whole concept of stars, there's sort of two big questions in my mind when people talk about them is, one is how do we know what they are with any sort of useful precision? Like no one knows exactly what the perfect rate of interest is at any given moment, but can we get close enough at any given moment for them to be a useful guide?

And two, are these useful concepts at all? I mean, they're inherently sort of unknowable, they're inherently sort of abstract, but are the stars a useful guide for policy period, or should we even be thinking in terms of stars? Both of those questions, I think, have a lot of relevancy and urgency these days.