But with a new Donald Trump administration in the White House, ‘pro-business’ domestic policies married to ‘America first’ trade policies are expected to add inflationary pressure, leading many to doubt whether even modest rate cuts can be delivered.

Much remains uncertain, and the constellation of policies actually adopted will be crucial to determining whether policymakers are compelled to keep rates higher-for-longer.

Over the long-term, where interest rates settle will be determined not just by the effects of Trump’s policies, but also by slow-moving structural trends – demographics, productivity and technology – both at home and abroad.

In the world of economics, the term r* (pronounced ‘r-star’) captures the balance of forces acting on interest rates. It might sound like academic jargon, because it is, but it’s a crucial concept. Considering its determinants can help us to understand the outlook for interest rates and its wide-ranging implications for investors. 

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Star power

r* - the equilibrium, natural, or neutral real rate – is the theoretical interest rate that would keep economic growth at its potential and inflation at its target level.

In simpler terms, it's the ‘Goldilocks’ interest rate at which monetary policy is neither stimulating nor restricting the economy – it’s keeping policy ‘just right’.

If the actual (inflation-adjusted) interest rate is below r*, monetary policy is considered stimulative – encouraging economic growth. Conversely, if the actual interest rate is above r*, monetary policy is restrictive – slowing down the economy.

Unfortunately, r* can’t be directly observed or measured, making it difficult for central banks to use it with confidence to determine the appropriate policy stance in their monthly meetings.

Starstruck

Considering the long-run trends in r* and its behaviour during the pandemic can still be informative for judging the long-term outlook for interest rates.

Over the long term, r* is established by the balance of desired saving and desired investment in the economy.

Since the 1980s, r* has been on a downward trend due to factors such as the slower growth in working-age populations, technological change reducing the cost of machinery and rising inequality. Many of these factors are likely to still weigh on interest rates going forward via their effects on saving and investment.

That said, the pandemic shocked rates higher, while new developments – specifically the emergence of artificial intelligence, investment needs associated with the green transition and higher military spending – could suggest that we have entered a world of permanently higher r*.

Written in the stars?

There are several reasons to believe that the pandemic shock to r* was not permanent.

Lockdowns caused widespread supply chain disruptions, fiscal stimulus reinforced household spending, goods demand surged as we all moved to ‘WFH’ and there were widespread labour shortages. Upward price pressures from these channels began to dissipate even before the pandemic ended.

The behaviour of inflation itself should also point to r* falling back. Inflation may still be a bit too hot for comfort, but it is greatly reduced from its peak, suggesting policy is in restrictive territory and that rates can likely be cut further before shifting to a neutral position.

If inflation proves to be more persistent, as it may do under new US leadership, it will be challenging (although not impossible) for the Federal Reserve to continue to reduce policy rates, since it could suggest that the neutral level has shifted higher, at least in the near-term.

Big questions will, however, remain over the long-run outlook. For example, expelling migrants from the US may add to inflationary pressure, but it will simultaneously weigh on growth and therefore investment and r*.

Moreover, a deeply interconnected global financial system suggests that adverse demographics and more conservative fiscal policy elsewhere can partially offset upward pressure on US bond yields.

Final thoughts

While r* may seem like an abstract concept, it affects everything from the cost of debt through to the value of stocks and property.

The pandemic interrupted many of the long-term themes influencing the global economy. But looking beyond the short term, many of the structural drivers of a low-interest rate world remain in play.

By keeping an eye on the factors influencing r* over the short- and long-term, investors can better navigate the shifting economic landscape and make more informed decisions.