In the simplest ways, r-star can be described as the rate of interest at which the economy neither grows nor slows. And it matters where the r-star is because interest rates matter. 

Here’s a quick flashback to how interest rates work. When the Federal Reserve wants to increase borrowing costs, one way it will do so is by raising the interest rate that depository institutions charge to lend each other reserve balances on an overnight basis, also known as the Federal funds rate. That, in turn, influences the rate that banks charge to lend to corporations and consumers. Meanwhile, when the central bank wants to boost economic activity, it will cut the rate to spur the borrowing of cheap money. 

But have you ever thought about how central bankers know when the economy needs higher or lower rates? 

Yes, they look at what economic reports like the consumer-price index and retail sales are coming in at to figure out if the economy is running too hot or cold, but in addition to that, they also measure whether monetary policy is tight or easy against the neutral rate (even if it can’t be measured precisely). 

The neutral rate, in this way, is like a lighthouse and it helps the central bankers sail the ship that is the economy through choppy waters. (Or if we wanted to continue to be silly with our Star Wars analogy, we could say that the neutral rate is like the Force inside of a lightsaber, which depending on the direction a central bank wishes to take, can change colors.) 

On Jan. 29, 2025, the Federal Reserve Chair Jerome Powell said this in response to a question about the neutral rate. 

“You can’t know with any precision, of course. As I like to say that you know the neutral rate by its works. I think you know at 4.3% we’re above pretty much everyone on the committee’s estimates of the longer-run neutral…You really have to just look out the window and see how your policy rate is affecting the economy, and I think we see that it’s having meaningful effects in bringing inflation under control. It has helped bring the labor market into balance as well…I would say, we’re meaningfully above it. I have no illusion that anyone knows precisely how much that is.” 

The relatively niche term has been discussed in political spheres, too. A few weeks later after that presser, this is what Powell said about the neutral rate during a congressional hearing.