R-star as an international price

I have written about r-star twice this year. The first post tried to pin down Australia's natural rate the standard way, a Holston-Laubach-Williams state-space model, trend growth and the IS curve doing the identifying work. It couldn't be done. The IS curve coefficient on the real rate gap came out at around minus 0.05, against quarter-to-quarter noise of about 0.7. A signal one-fourteenth the size of the noise floor cannot identify anything. Every variant I tried failed the same way, the latent r-star collapsing onto whichever prior I fed it.

The second post started with the premise that liquidity is global, and in every country investment seeks out the best returns in the world. The standard approach to r-star instead asks Australian output and inflation to reveal the real interest rate that balances desired saving and investment, as though that equilibrium were fundamentally domestic. But saving and investment now meet in a global capital market. A single global market still leaves room for a country-specific wedge, the way a single global oil market leaves room for regional basis differentials between Brent, WTI and everything else. The wedge is the local story. The level it sits on top of is not.

This post takes that global understanding and uses it to model Australia's neutral real rate of interest, r-star. World r-star plus the Australian wedge gives Australian r-star, rather than Australian output, inflation and trend growth being asked to produce one on their own. Australia's own market tells you the wedge on top, not the underlying price.

The Australian Economy Right Now

Four numbers rarely line up the way they have this year. Growth sits above potential. Unemployment sits below the non-accelerating inflation rate of unemployment (NAIRU). Inflation sits above the target band. And the cash rate sits above the neutral rate, r*, but still short of what a standard Taylor rule would prescribe. Put together, these estimates describe an economy running hot while policy leans against it, but not hard enough.

Growth Has Overtaken Potential

Headline GDP growth through the year is running at 2.14%, although most of that growth happened in the tail end of 2025. Growth in the first half of 2026 was much more modest.

The New Keynesian Synthesis, Explained

When a central bank moves the cash rate, it’s acting on a specific model of how the economy works. That model is the New Keynesian synthesis, and it’s the closest thing modern economics has to an operating manual for monetary policy. Every inflation target, every rate decision, every line in a central bank statement about “returning inflation to target” comes out of this framework. Understanding it is the difference between watching the news cycle of rate rises and cuts and actually seeing the logic behind it.

This isn’t a history of how these ideas came together, nor an account of what exactly got synthesised between classical and Keynesian economics. It’s a walk through the intuition: how the pieces of the model fit together, and where they hold up worse than the theory suggests.

Output and Output Gaps

Every economy has a speed limit. Economists call it potential output, or Y*. It represents how much an economy can produce when its workers, factories, and capital are all fully but sustainably employed. Actual output (also known as GDP or Y) moves around this limit. The difference between the two, Y minus Y*, is called the output gap. Sometimes it’s negative and Y sits below Y*, and resources go idle. Sometimes it’s positive and Y pushes above Y*, and something has to give.

What a Real Bond Crisis Looks Like

People throw around the word "crisis" every time yields move. It's worth being precise about what that word actually covers, because the different versions call for completely different responses.

Markets reprice all the time as new information arrives. That's their job. A repricing on its own is not news. What matters is the size of the move, the speed of the move, and whether anything underneath the market itself is breaking. Those questions are what separate the ordinary from an actual crisis.

Potential: the speed limit for the economy

Every few weeks someone describes potential growth as the economy’s speed limit. The metaphor is useful, but it is attached to the wrong thing. The real speed limit is potential output, the level: the amount the economy can produce sustainably with inflation at target. Potential growth is only the rate at which that limit itself moves. The two answer different questions, and mixing them up produces bad readings of the cycle.

This post uses a small model of Australian potential output to make one point. Conventionally, the output gap is the difference between actual and potential output, a difference between two levels. This model goes one step further and splits that observed difference into an inflation-related component and a residual. Potential growth tells you how fast the potential level is moving. It does not tell you the sign of the gap, and neither potential growth nor observed GDP growth on its own tells you where inflationary pressure sits.

Two levels and the distance between them

Let's not mention the war

The latest in a series of monthly reflections on the war in Iran.

Six months ago the United States began the largest military campaign it has fought since 2003. It killed a head of state on the first morning. It has struck more than eleven thousand targets. Eighteen American service members are dead and 756 wounded. The Strait of Hormuz has been closed (again) since 11 July.

You would barely know it.

That is not an accident, and I do not think it is simple neglect. The silence is the most informative thing that happened in August.

Weekly Energy Update

 Status

• Petrol prices - elevated but stable in August. 
• Singapore refined - elevated
• Crude prices - elevated 
• Natural gas - above early Iran war prices

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