Neutral rate: There’s no need for a ‘pole star’ to guide RBI’s policy

livemint.com:

The pole star, also referred to as North Star, has been synonymous with surety or precision and has been relied upon by humans since time immemorial. In essence, there is no effect of the Earth’s rotation on the angle of vision between our planet and the pole star, giving the impression that it does not move as the night passes.

In monetary policy, the neutral rate, or ‘R-star,’ has been a guiding light for central banks and is an important concept in economics. It is the hypothetical level of the interest rate that, when all temporary shocks have faded out, can set the economy on a sustainable path of balanced growth and on-target inflation.

Interest rates above this rate indicate that the central bank’s monetary policy stance is restrictive, and below it, accommodative or expansionary. Two references have been made recently to the R-star.

First, the March 2024 Bank for International Settlements paper, Quo vadis, r*? The Natural Rate of Interest after the Pandemic, avers that “estimates of the natural rate of interest (r*) suggest that it may have increased relative to pre-pandemic levels." It goes on to say that “potential shifts in the saving-investment balance and a more inflationary environment, which elicited a strong monetary policy response, may have raised r* and perceptions thereof." The implication for central banks and stakeholders could be huge, as it means that the current monetary policy stance isn’t as tight as most market players and analysts think. If the R-star is higher than it was pre-covid, then one should expect inflation and interest rates to remain higher or even rise, instead of falling, even after the one-off effects of the pandemic, hot wars and supply-chain disruptions subside.