Finding neutral: The path to an economy in balance

R-star is the rate of interest that, theoretically, neither stimulates nor restricts an economy at full employment. Talk of r-star is bound to surface more frequently now that the Federal Reserve has embarked on a cycle of monetary policy easing amid cooling inflation and a softening labor market.

Vanguard economists have been saying for more than a year that r-star—also known as the neutral, natural, or long-run equilibrium rate of interest—has risen in recent years and is higher than most observers have thought.

In a June 2023 technical paper, Vanguard Global Chief Economist Joseph H. Davis and coauthors Ryan Zalla, Joana Rocha, and Josh Hirt contend that r-star is roughly 3.5% in nominal terms, or 1.5% when adjusted for the Fed’s 2% inflation target. Their findings suggest that higher interest rates than we became accustomed to before the COVID-19 pandemic would be required for an economy in balance.

Fed policymakers have acknowledged the likelihood of a higher neutral rate, nudging up their own estimates three times this year, from a median nominal level of 2.5% to the current 2.9%. We expect further Fed rate cuts in 2024 and 2025 to bring the policy interest rate closer to neutral.

Looking at data from 1940–2022, conventional models for estimating r-star, and a Fed model for forecasting and analysis of macroeconomic issues, our researchers conclude that an aging population and rising fiscal deficits have pushed up the neutral rate of interest by about 100 basis points (1 percentage point) since the 2008 global financial crisis.

Explore the technical paper, R-star is higher. Here’s why. And get Vanguard’s current views on the Fed in our economics and markets hub.

• Our investment and economic outlook, September 2024 (article, issued September 2024)
• Vanguard economist says it’s time to tilt toward bonds (commentary, issued September 2024)
• A new day for Federal Reserve policy (1:59 video, issued September 2024)