If you can, try to spend even just a few minutes at night looking up at the stars. They are a little slice of beauty, no matter what it looks like in front of you from day to day. For more wonderment, follow @nasa, and you’ll be even more amazed at how big and beautiful the universe is—and just how small the slice you can see really is. 

Stars exist not only in the sky but also in economic discussions. Specifically, there has been quite a bit recently written and talked about of concepts called “r star” (r*) and “g star” (g*).  r* is the neutral real interest rate—essentially the average expected Fed interest rate, over the long term, excluding inflation. g* is the long-term expected growth rate of the US economy. These concepts have caught attention recently because of how markers of r and g have been rising.

NB: A relationship to understand is that r* is the average long-term interest rate minus average long-term inflation. If inflation is falling (like now) but rates are staying the same, that means r* is higher. And g* is considered to be inversely related to inflation—meaning high inflation often leads to low growth. 

It wasn’t so long ago (2019) that Fed officials claimed r* was a low number—just 0.5%. And that was believable for quite a while given the dynamics of slow growth and low inflation after the Global Financial Crises. But, now, with measures like inflation starting to fall, but growth rising, and unemployment staying low, many are saying: nah, that r* estimate can’t be right. 

One measure of “long-term real rates” is the market’s projections of the five year rate, in five years (often called the 5 year/5 year), less inflation expectations. Shown here:

You can see how this estimate fell for quite a while, but starting in 2022, it began to rise and is now close to 2%.

 What could be causing r* to be higher? 

• Years of growing the US deficit (as discussed last week). The more debt you have, the higher costs should be (e.g., if your friend already owed you a lot of money, would you charge them more or less for the next dollar they borrowed?). 

• Higher growth, thanks to technology (like AI) that boosts productivity, and a newer focus on clean energy technology given the government bills passed in the last year. 

• Demographics that support higher rates as the Baby Boomer generation is now in retirement/spending vs. working/saving mode. As they have left the workforce, they spend more, creating growth while also lowering the supply of workers. That lower supply means, all else equal, wages must stay higher, contributing to consumption growth—and inflation.

Of course, these same things could end up doing the opposite over time. The US average age is rising, which could eventually lead to slower growth, while continued technology could reduce the need for capital, and thus, the need to borrow, keeping r* low.

However, I am in the camp that r* is actually higher than that 2019 Fed estimate (as previously shared in June and March). 

The implications of a higher r* is that despite the Fed raising rates by over 5% this year, the Fed Funds rate is not actually “sufficiently restrictive”—a term they’ve used to state their goal of restricting growth in order to stamp out inflation. The fear, of course, is that the Fed has to raise rates much higher than expected—which has been contributing to a negative sentiment in the stock market since the start of August. The other, perhaps positive implication, is that it forces the hand for the deficit of the US government to fall, perhaps without severely impacting the long-term growth of the economy. Or, at least I can wish that on a star.

Fed Chair J. Powell will be speaking this Friday at the annual Fed conference in Jackson Hole, WY. While I don’t expect his speech to make as big of an impact on the markets as it did last year, I believe he could talk tougher than many expect. Because while inflation has fallen, he will want to leave the door open to taking more action, if needed, to ensure it stays this way. But he himself has warned not to assume future policy based on something like r*, since it’s more concept than observable. 

Sort of like navigating around a city using only the stars. They are better left for observation than action — even if they can tell you which way North is.