Where’s neutral? We still don’t know. Indeed, we can’t know. But sometimes, the data suggests it’s higher than the Fed and economists’ models are willing to admit.

The r-star discussion isn’t front page news anymore, but maybe it should be. It wasn’t all that long ago (i.e., just a few months) when the financial pages were replete with references to the unobservable. R-star might be esoteric, but market participants briefly became obsessed with the concept late last summer.

Any number of excuses have been floated for the US economy’s resilience to Fed hikes this cycle, but at a conceptual level, it may be that rates simply aren’t high enough in the context of a new macro regime.

Of course, if you insist this isn’t a new macro regime (defined by structurally higher inflation, robust nominal growth and “more fiscal,” so to speak) then you won’t be inclined to accept the notion that rates actually aren’t all that restrictive after 525bps of Fed hikes. And yet, as noted above, the debate feels like an example of “Me or your lyin’ eyes?” during some weeks.

Fed officials routinely insist that policy’s restrictive. Indeed, they state as much as though it were an incontrovertible fact that admits of no ambiguity. That’s ironic because you could argue that far from being settled, the balance of evidence suggests precisely the opposite of the Fed’s line: Policy isn’t unduly restrictive if it’s restrictive at all. And if anything admits of ambiguity, it’s r-star.

In a rare instance of a Fed official being forthcoming about this issue, no less than Jerome Powell said the following during a fireside chat session at an October event hosted by The Economic Club of New York:

We have models for everything, we have formulas for everything. Ultimately, as a practitioner, we have to focus on what the economy is telling us. Does it feel like policy is too tight right now? I would have to say no.

The macro might’ve softened since then, but not by enough to alter that assessment. And it anyway doesn’t appear to matter: The most recent data releases, sans PMIs, arguably suggest the economy’s re-accelerating.

Meanwhile, we’re supposed to believe that r-star isn’t materially different from the estimated levels covering the period between 2009 and 2019.

Although seven long run dots say otherwise (where “otherwise” means they argue for a higher natural rate), the median remains 2.5% (nominal, obviously).

That, ultimately, is what underpins Fed officials’ contention that policy is unequivocally restrictive. The gap between current policy settings and assumptions about r-star is wide enough that rates would still count as restrictive even if neutral is materially underestimated.

But… well, as JonesTrading’s Mike O’Rourke not-so-gently noted, “there is little to no evidence in the economic data or the financial markets that policy is restrictive.”

He pointed to new highs for stocks (mostly thanks to multiple expansion), and ongoing resilience in the real economy to suggest that at the very least, “economic and financial market action do not indicate a need for easing.”

There are two key points, both of which O’Rourke hit. First, myriad supply-side distortions plus a ground war in Europe allowed the Fed to argue that not all of the inflation impulse in 2021 and 2022 was the fault of monetary policy, but that argument wouldn’t be as convincing if price pressures were to pick back up after prospective rate cuts in 2024.

Second, if the Fed isn’t willing to state, forcefully and formally, that the Committee is confident r-star isn’t materially higher, then forceful, formal declarations about restrictive policy are, at best, hopelessly imprecise and at worst, completely disingenuous — by definition.

“If the natural rate has shifted upwards and the [Fed] eases amidst a strong economic backdrop, it would likely prompt a re-acceleration of inflation” and given record stock prices and decent economic data, “it would be hard to place blame elsewhere,” O’Rourke said, adding that “until the FOMC can express with confidence what it believes the natural rate of interest is, it should move cautiously on rates.”

All of that said, O’Rourke conceded that in practice, caution will probably be thrown to the wind. “We offer the caveat that the US government and its central bank are among the few places in the world where math does not need to add up,” he said.