R-Star, often written as r∗, stands for the “natural rate of interest.”
It is a term used in economics to describe the ideal interest rate for an economy.
This means it’s the rate at which the economy is growing at its potential, with full employment and stable inflation.
Think of r-star as the Goldilocks rate—neither too hot nor too cold.
It’s like a sweet spot where the economy is doing just right—not too hot (with high inflation) and not too cold (with high unemployment).
What is R-star?
R-Star is the rate at which the economy is neither overheating (leading to high inflation) nor underperforming (leading to high unemployment).
It’s the theoretical real (inflation-adjusted) short-term interest rate that would prevail when an economy is operating at full employment and stable inflation.
In other words, it’s the interest rate that neither stimulates nor hinders economic growth.
Estimates of r-star can vary over time and across different economies.
Central banks use r-star as a reference point for setting monetary policy, but it’s not the only factor they consider.
How is R-star measured?
R-star is not directly observable and can only be estimated using economic models.
Economists use various models and techniques to derive estimates of r-star, which can vary depending on the methodology and assumptions used.
These models consider various factors to gauge what the natural interest rate should be.
Here are some of the main factors used:
- Productivity Growth: If workers and businesses are becoming more efficient, the economy can sustain a higher interest rate.
- Demographic Trends: An aging population can lead to lower savings and investments, affecting the natural rate of interest.
- Global Economic Conditions: International trade and investment flows can influence R-star. For example, if many countries are experiencing slow growth, it can drag down the natural rate globally.
- Inflation Expectations: Expectations about future inflation can also impact the natural rate.
Why is R-star important?
Central banks like the Federal Reserve use r-star as a guidepost for setting interest rates.
If the current interest rate is below r-star, it suggests that monetary policy is accommodative (stimulating the economy).
Conversely, if the current interest rate is above r-star, it indicates that policy is restrictive (slowing down the economy).
By comparing the current real interest rate to R-Star, central banks can decide whether to stimulate the economy or cool it down,
R-star can help policymakers and economists assess the overall health of an economy. Changes in r-star can signal shifts in underlying economic fundamentals, such as productivity growth or demographics.
The Importance of R-star for Forex Traders
For currency traders, understanding r-star is vital for several reasons:
- Monetary Policy Insights: Central banks’ decisions on interest rates significantly affect currency values. If a central bank is likely to raise rates because the current rate is below r-star, this can lead to a stronger currency. Conversely, if rates are expected to be cut, the currency may weaken.
- Inflation and Growth Signals: R-star helps traders gauge future economic conditions. If the real interest rate is above r-star, it might signal slower growth and lower inflation, impacting currency expectations. If it’s below, faster growth and higher inflation might be anticipated.
Practical Example of R-star
Imagine you’re a trader focusing on the U.S. dollar (USD).
The Federal Reserve has estimated the U.S. r-star to be around 2.5%.
Currently, the real interest rate is 1.5%.
This means the real rate is 1% below the r-star, suggesting that the Federal Reserve might raise interest rates in the future to bring the real rate closer to the natural rate.
Anticipating this, you might expect the USD to strengthen as higher interest rates typically attract foreign investment.