Neutral Interest Rate (R-Star)

The neutral interest rate, written r* and spoken "r-star", is the real short-term interest rate at which monetary policy is neither expansionary nor contractionary. At that rate the economy grows in line with its potential, unemployment sits near its natural level and inflation is stable. When a central bank's policy rate, adjusted for inflation, is above r*, policy is restrictive; when it is below, policy is stimulative.

The idea is also called the natural rate of interest or the equilibrium real rate. It cannot be observed directly and must be estimated from models, so estimates differ widely. It plays a central role in the Taylor rule, in debates over the zero lower bound, and in judging how tight policy at the Federal Reserve, the ECB or the Bank of England really is.

Think of driving a car on a flat road. Press the accelerator and you speed up; press the brake and you slow down. The neutral rate is the position where your foot is on neither pedal and the car holds its speed. A central bank wants to know where that point is so it can tell whether it is pressing the brake or the accelerator.

The catch is that the road is not always flat, and nobody can see the gradient. If the economy is facing a long uphill climb, a setting that looks neutral may actually slow it. That uncertainty is why estimates of the neutral rate are debated so heavily.

The Swedish economist Knut Wicksell introduced the "natural rate of interest" in 1898, describing it as the rate at which prices tend neither to rise nor fall. Modern versions distinguish a short-run neutral rate, which moves with temporary shocks, from a longer-run r* that reflects slow forces such as productivity growth, population trends and the demand for saving. Because r* is a real rate, the nominal neutral policy rate is roughly r* plus expected inflation, using the Fisher relation that links the nominal interest rate to real terms.

The Taylor rule shows how r* enters a simple prescription for the policy rate:

• $i$ is the recommended nominal policy rate.
• $r^{*}$ is the neutral real interest rate.
• $\pi$ is current inflation and $\pi^{*}$ is the inflation target.
• $y - y^{*}$ is the output gap, the percentage gap between actual and potential output.

With r* at 1%, inflation at 3%, a 2% target and output at potential, the rule gives $1 + 3 + 0.5 \times 1 + 0 = 4.5\%$. If r* were 0.5% instead, the same economy would call for 4%. A half-point mistake about r* therefore changes the prescribed rate by a half point.

The best-known US estimates come from the Laubach–Williams model (2003) and its successor, Holston–Laubach–Williams, published by the Federal Reserve Bank of New York. They infer r* from the relationship between interest rates, output and inflation. Other approaches use long-term bond yields, surveys of forecasters, and the long-run rate expectations of policymakers. In its September 2026 projections the median FOMC participant put the longer-run federal funds rate at 3.2% with 2% inflation, which implies a real neutral rate of about 1.2%. An ECB analysis published in 2025 put the nominal neutral rate for the euro area at roughly 1.75–2.25%.

Most estimates show r* in advanced economies falling from around 2–3% in the 1990s to below 1% after the 2008 Financial Crisis. Explanations include:

• Slower trend growth. Weaker productivity growth lowers the return on new investment.
• Ageing populations. Longer retirements raise the desire to save, a theme in demographic economics.
• A global saving glut. Former Fed chair Ben Bernanke argued in 2005 that high saving in Asia and oil exporters pushed down world rates.
• Demand for safe assets. Investors and banks seeking safe, liquid bonds bid down their yields.

Since 2022 some economists have argued that r* has risen, pointing to large government deficits, defence and energy-transition spending, and investment in artificial intelligence. Others find little change once temporary factors are removed. A low r* matters because it leaves less room to cut rates before hitting zero, raising the risk of a liquidity trap and of long periods of stagnation.

Estimates of r* are imprecise: confidence bands are often several percentage points wide, and estimates are revised heavily as new data arrive. Critics, including some members of the FOMC, warn against steering policy by an unobservable number; Fed Chair Jerome Powell in 2018 compared relying on such stars to navigating under cloudy skies. Some economists, especially in the Austrian tradition, reject the idea that a central bank can know the right rate at all. Others argue that r* is still useful as a rough benchmark for the stance of policy, alongside the Phillips curve and measures of the natural rate of unemployment.

• Federal Reserve Bank of New York: Measuring the Natural Rate of Interest
• Federal Reserve: Summary of Economic Projections, September 2026