Neutral Interest Rate (r*)
Quick Definition
The theoretical interest rate that neither stimulates nor restricts economic growth, keeping the economy at full employment with stable inflation.
Key Takeaways
- The real rate where monetary policy is neither stimulative nor restrictive
- Unobservable—must be estimated, creating significant uncertainty
- U.S. estimates have declined from 2-3% (1990s) to 0.5-1.5% (recent)
- Rates below neutral stimulate growth; above neutral restrict it
- Central to determining whether monetary policy is "tight" or "loose"
What Is Neutral Interest Rate (r*)?
The neutral interest rate (also called r-star or r*) is the real short-term interest rate that would prevail when the economy is at full employment and inflation is stable at the central bank's target. At this rate, monetary policy is neither stimulative (encouraging excess spending) nor restrictive (constraining activity). When the actual real rate is below neutral, monetary policy is accommodative and stimulates growth; when above neutral, policy is restrictive and slows the economy. The neutral rate is unobservable and must be estimated, making it one of the most debated concepts in monetary policy. Estimates for the U.S. neutral rate have declined from approximately 2-3% in the 1990s to 0.5-1.5% in recent decades, reflecting factors like aging demographics, slower productivity growth, and the global savings glut. The Fed's Summary of Economic Projections includes estimates of the longer-run federal funds rate, which approximates the neutral rate plus the inflation target.
Neutral Interest Rate (r*) Example
- 1The Fed's Summary of Economic Projections estimated the longer-run neutral rate at approximately 2.5% nominal (0.5% real plus 2% inflation target).
- 2When the federal funds rate was 5.25% and the estimated neutral rate was 2.5%, monetary policy was considered significantly restrictive.
- 3Economists debated whether post-pandemic structural changes—higher government spending, deglobalization—had permanently raised the neutral rate from its pre-COVID lows.
Related Terms
Real Interest Rate
The interest rate adjusted for inflation, representing the true cost of borrowing or the true return on savings in terms of purchasing power.
Federal Funds Rate
The interest rate at which banks lend reserve balances to each other overnight, set as a target range by the Federal Reserve.
Monetary Policy
Actions by a central bank to manage the money supply and interest rates to achieve macroeconomic objectives like stable prices and full employment.
Federal Reserve (The Fed)
The central banking system of the United States, responsible for monetary policy, bank regulation, and financial stability.
Secular Stagnation
A prolonged period of slow economic growth and low interest rates caused by structural factors like aging demographics, weak investment demand, and excess savings.
Expand Your Financial Vocabulary
Explore 130+ financial terms with definitions, examples, and formulas
Browse Macroeconomics Terms