Seeing Australian r-star through different windows

How do you estimate something you cannot observe?

That is the basic problem with r-star, the neutral real interest rate. In the standard monetary-policy framework, it is the real interest rate consistent with the economy operating at potential and inflation stable. Put the real policy rate below r-star and monetary policy should stimulate demand. Put it above r-star and policy should restrain it.

But r-star is not a market price we can look up. It has to be inferred from other things we can observe, using some model of how those things relate to it.

I started trying to estimate an Australian r-star using the standard Holston-Laubach-Williams (HLW) model. That attempt failed. The Australian data did not contain enough information for the model to identify the relationship it needed to recover r-star.

That failure led to a different question. If I cannot see Australian r-star through the HLW model, can I see it through other windows?

I have now tried three. One looks at international and Australian bond markets. One looks at the RBA's own interest-rate decisions. The third imposes the IS relationship that HLW failed to estimate and works backwards to the r-star required to make it hold.

These are not minor variations on the same model. They obtain their information about r-star from quite different places. All three estimate cleanly. More importantly, all three recover a recognisably similar low-frequency history: Australian r-star was much higher, fell substantially over the decades before COVID, and has risen again since the pandemic.

But they disagree materially about exactly where r-star sits.

That combination is the interesting result. I have a much better window on the direction of Australian r-star than I do on its level.

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.

QE and the Estimated Neutral Rate

TL;DR

Money for long-term borrowing moves freely across borders, so liquidity is a global phenomenon. QE bought bonds from asset holders and paid in cash. With this cash they bought other assets, everywhere and in every class. Asset prices rose worldwide, including in countries that never ran a QE programme of their own.

That was inflation, in a market the consumer price index does not cover. And bidding an asset's price up is bidding its yield down, so the same event was a global fall in borrowing costs.

None of this began in 2009. Bernanke saw low rates in 2005 and diagnosed a global savings glut as the cause, favouring a structural explanation over a liquidity one.

Most econometric models that estimate the neutral rate are fitted to consumer prices, output and interest rates. Asset prices are not among the inputs. So the figure they report is the rate that is neutral for groceries, and it has nothing to say about whether borrowing was running ahead of the capacity to service it.

There is a second problem underneath. The models infer the rate from two relationships that a decade of successful stabilisation had flattened, leaving the history of the policy rate itself as the main thing to lean on. Policy rules then took that estimate as an input, and naturally recommended something close to the policy already in place.

Estimation needs variation, and stabilisation exists to remove variation. A central bank that succeeds gradually erases the evidence it needs to keep doing its job.

The liquidity story does the work of several. It explains why asset prices boomed where no programme ran, why consumer prices stayed quiet and then surged in 2021 when the same mechanics reached households instead, and why every country's estimate fell together despite different demographics, deficits and growth.

For a decade, the rate that would have kept borrowing serviceable sat far above the one the models report. That is not a measurement problem. It is a specification problem, and a specification problem returns a confident number to the wrong question.

Finding r-star after the Great Divergence

TL;DR: r-star, the real neutral rate of interest, is one of the unobservable star variables in mainstream macroeconomics. It is notoriously hard to estimate. The Australian IS curve coefficient on the real-rate gap is small relative to macro noise, so the model cannot choose between a growth anchor, a bond-yield anchor, or a blend of the two. Those three approaches, drawing on Wicksell, imply a real r-star between roughly 1.5 and 2.6 per cent, and a nominal neutral cash rate between about 4.0 and 5.1 per cent. With the RBA policy cash rate at 4.35 per cent, policy is not extreme. The data alone does not say whether it is mildly restrictive or mildly accommodative. The post-GFC track record and Governor Bullock’s recent language both lean toward the yield-anchored interpretation, on which 4.35 per cent is mildly restrictive.