Last week in Zurich, Richard Clarida, vice chairman of the US Federal Reserve bank, made a speech[1] about how monetary policy—the raising and lowering of interest rates—has become more challenging in a low inflation environment. Among the figures and evidence he presented was startling picture of what central bankers call r*.
r* is a calculation of the natural rate of interest, or roughly the short term or risk-free interest rate that would prevail if monetary policy was neutral (not trying to boost or slow the economy). It fell after the financial crisis and stayed low and is beginning to look like what economists call a structural change. Asset prices tend to move around, but sometimes they change permanently, or their natural level changes for a very long time. That r* has stayed so low for more than 10 years suggests a big change.
Federal Reserve
Although r* doesn’t represent a bond that is directly traded, it is one of the most important interest rates in the economy. First it tells us (and central bankers) if monetary policy is expansionary or not: If they set rates above or below r* they are contracting or juicing the economy. But r* is also the foundation of the bond market. Bond yields are a function of r*, expected inflation, and a premium to compensate investors for bearing the risks involved with holding bonds for longer. A structurally lower r* means lower interest rates on all bonds, and this can have profound implications for the economy.
Why did it change?
The trend is global so whatever changed, it happened to all industrial countries. Economists cite several factors[2] (pdf)...