The Most Important Economic Data You’ve Never Heard Of: R-Star

Federal Reserve officials watch hundreds of economic data series. Among the most important is this one. The Fed chairman even spoke about it recently.

Many investors watch unemployment rates and inflation. These are important pieces of information. That’s why the Federal Reserve watches those two data series.

Fed officials watch hundreds of data series. Among the most important could be r-star. Fed Chairman Jerome Powell even talked about r-star in his widely watched Jackson Hole speech.

R-star is the theoretical after-inflation short-term interest rate. It changes with economic growth and inflation.

Few investors thought about r-star before Powell’s speech. But now they understand how important it is.

Powell explained that there are three stars. R-star is the neutral real interest rate. That’s the rate that leads to stable employment and a growing economy. The Fed’s goal is to guide interest rates to r-star.

There’s also u-star, the ideal unemployment rate. And there’s pi-star, the ideal inflation rate. Central bankers usually tell us inflation should be about 2%.

Powell noted: “According to the conventional thinking, policymakers should navigate by these stars.”

But that’s bad news for fixed-income investors.

Economic Growth Affects R-Star

For many years, r-star was between 2% and 3%. Now it’s about 1%. With 2% inflation, interest rates will stay near 3%.

Federal Reserve officials watch hundreds of economic data series. Among the most important is this one. The Fed chairman even spoke about it recently.(Source: Federal Reserve)

Interest rates for investors or borrowers include an inflation premium. So the rate on a 10-year Treasury note was about 5% or more when r-star was above 2%.

But all that changed. During the financial crisis, r-star fell. And it didn’t recover. That means interest rates might be lower for many years.

Economic growth affects r-star. Higher growth leads to higher interest rates.

Growth is back above 3%. But many investors expect it to drop again. That’s important.

Expectations affect r-star. Expected economic growth is important. Expected inflation is also important. When expectations rise, r-star rises.

If investors expect slow growth and low inflation, r-star remains low. It’s not likely that expectations will change suddenly.

Media Coverage of Economic Data

Experience and media coverage drive economic expectations.

Experience drives inflation expectations, and inflation is low. It’s been below 3% for most of the last 10 years.

Consumers expect that to continue. The Fed expects inflation to drop back to 2%. That means there’s no pressure to increase r-star.

Media coverage is pessimistic. That’s true for most of the past 10 years.

When economic growth was slow, analysts told us that was the new normal. Now that growth accelerated, analysts tell us it won’t last.

That negative tone, and expectations for low inflation, will keep interest rates low. That’s important for investors.

Low Rates Are Bullish for Stocks

R-star is 1%. Inflation is 2%, according to the Fed. That means interest rates should stay below 3%.

Low rates don’t support retirement. That drives investors to stocks, which is bullish for stocks. And there’s no reason to expect that to change.

Powell also noted in his speech that he admired Fed Chairman Alan Greenspan’s style. Greenspan allowed the stock market to boom in the 1990s. He did that by keeping interest rates low.

Powell seems like he wants to imitate Greenspan. He wants to ignore the stars as much as he can.

That’s good for investors. Greenspan allowed a bubble to develop in stocks. Powell may do the same.

Investors should expect a crash after that bubble. But they should enjoy the bubble while it lasts.

Regards,

Michael Carr, CMT

Editor, Peak Velocity Trader

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