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

Episode Summary

Executive Summary: The episode examines “stars” in macroeconomics—especially r-star, the neutral interest rate—and why they matter for understanding inflation, slack, and policy. IMF researcher Peter Williams explains how his model estimates these unobservable variables, why r-star appears lower than many peers estimate, and how the post-2008 and post-COVID economy has challenged traditional monetary policy frameworks.

Main Topics: What the ‘stars’ are (Priority: 5/5): The hosts define the stars as long-run equilibrium concepts used by central bankers: r-star (neutral rate), potential output, potential growth, natural unemployment, and the inflation target. Why r-star matters for policy (Priority: 5/5): R-star helps policymakers judge whether policy is restrictive or accommodative, especially when inflation and unemployment behave differently than older models predicted. Historical roots and post-crisis popularity (Priority: 4/5): The discussion traces r-star back to Knut Wicksell and notes that it became much more salient after the financial crisis when standard relationships seemed to break down. Peter Williams’ IMF model (Priority: 5/5): Williams explains his paper ‘Reading the Stars,’ which anchors estimates around a 2% inflation target and uses inflation, output, labor market, and financial variables to infer the stars. Why r-star may be lower than expected (Priority: 5/5): The model suggests the neutral rate is unusually low because the post-crisis recovery was slow, implying policy was less supportive than assumed and slack persisted longer. Financial crisis and policy misreads (Priority: 4/5): The paper implies the pre-2008 boom was more a credit-fueled deterioration in potential conditions than a clear overheating of the real economy, and that forecasters overestimated how quickly normal would return. Critiques, ideology, and alternative data (Priority: 3/5): The conversation addresses heterodox criticism of mainstream macro and the limits of real-time estimation, including whether newer data streams can improve nowcasting without long histories.

Key Arguments: Central bankers rely on equilibrium ‘stars’ because they need guideposts for assessing policy stance in a noisy, changing economy. The post-2008 economy broke familiar patterns: unemployment fell slowly, growth stayed weak, and low rates did not generate expected inflation. Williams’ model fixes the long-run inflation target at 2%, then estimates other variables around that anchor to infer slack and the neutral rate. The IMF paper’s r-star estimate is lower than many academic estimates because the recovery was prolonged and policy may have been less supportive than standard assumptions implied. Before the financial crisis, growth was supported by credit expansion, but the model suggests underlying potential growth and other stars were deteriorating. Traditional simple methods often used moving averages or trends, but more modern approaches add inflation drivers, GDP, income, unemployment, and shadow rates to improve identification. Alternative data are useful for nowcasting during shocks like COVID, but short histories and noisy relationships make formal incorporation difficult. Heterodox critiques that mainstream macro is purely ideological are rejected; Williams argues policymakers need structured models to make decisions, even if imperfect.

Data Points: Stock Movers report length: five minutes or less - Bloomberg promo introducing short stock-market audio updates Fed inflation target: 2% - Used as the anchor for the model and long-run inflation objective John Taylor’s rule assumption for r-star: 2 - Described as the classic benchmark embedded in monetary policy research Great Moderation period: 1990 to 2008 - The period when r-star and other stars appeared relatively stable Post-crisis recovery horizon in private/FOMC forecasts: 3 to 4 years - Initial expectation for returning to normal after the financial crisis 2018 Jackson Hole speech: Jerome Powell speech on r-star - Identified as a key inspiration for Williams’ paper COVID shock GDP print: historically unprecedentedly bad in Q2 - Used as an example of data breaking normal relationships Unemployment rate in the model’s implied long run: around 3.9% to 4% - Presented as close to maximum employment / frictional unemployment Bloomberg global workforce cited in promos: 3,000 journalists and analysts - Repeated promotional mention of Bloomberg reporting scale

Pivotal Quotes: "we keep asking policymakers if they actually understand inflation" — Joe Weisenthal: Sets up the episode’s core skepticism about central bank inflation theory "the stars are pieces of the missing inflation puzzle" — Tracy Allaway: Explains why r-star, potential output, and related variables matter to policy debates "the neutral rate and these stars as sort of helping give us a bit more context for where we are relative to where we kind of should be" — Peter Williams: Williams’ analogy for why equilibrium concepts remain useful despite uncertainty

Implications: The discussion suggests policymakers may need to keep rates lower for longer and use a broader toolkit. It also implies that post-crisis inflation and labor-market dynamics may require rethinking standard models and assumptions.