The theoretical anchor of monetary policy is on the rise after waves of technological and fiscal change
Every monetary policy decision is in essence a measurement of distance. Monetary policymakers have to have a sense of where the economy is relative to a theoretical ideal to know how much to ease or tighten. That ideal is captured by what economists call the neutral rate of interest, or R-star (r*).
R-star is the real interest rate compatible with full employment and 2% inflation. When actual rates are below this theoretical barometer, monetary policy is accommodative. When rates are above, policy is contractionary. The most important question in macroeconomics in 2026 is no longer about rate cuts, but rather about the policy normalization puzzle: how far will the Fed go? An emerging consensus is forming that R-star is permanently higher than it used to be. Letโs examine this critical development and its market implications
Measuring the Unmeasurable
Since R-star is a theoretical construct not directly visible in financial markets, it has to be estimated using indirect methods. The most common approach is the Laubach-Williams model, which the Fed used extensively throughout the 2010s to justify its aggressive pivot towards near-zero rates.
This year, newer studies are suggesting that the neutral rate may actually be higher, not lower, than previously estimated. The most compelling research comes from the Cleveland
Fedโs Zaman, whose new model captures the relationship between R-star (๐* ), trend economic
๐ก
growth (๐* ), and permanent forces shaping the macroeconomic outlook (๐ท ). Specifically:
๐ก ๐ก ๐= 0.65๐ + ๐ท ๐ก ๐ก ๐ก
Using this equation and the data through early 2026, Zaman estimates that the medium-term neutral rate is actually around 3.7%. If the Fed Funds rate is between 3.50% and 4.25%, as it is for much of the time period under consideration, monetary policy is either very slightly contractionary or precisely at neutral. Either way, the central bank has relatively limited room for error in the face of a recession.
Why Is R-Star Rising? The zero-lower bound (ZLB) policy of quantitative easing and near-zero rates was necessitated by a combination of weakness in trend growth, aging populations, and a global savings glut. In contrast, several powerful forces are now conspiring to push R-star higher: Structural Driver Impact Mechanism
on R-Star
The AI Capex Upward PIMCO estimates that building AI infrastructure Boom (on top of energy transitions) will require $14
trillion in investments over the next 5 years. A huge amount of money is needed to meet the demand for investment capital, thus pushing up the neutral rate.
Deficit Spending Upward An extended sovereign debt issuance increases
the supply of bonds. In order to find buyers for this large supply of government debt, the baseline yields must increase.
Deglobalization Upward The unraveling of hyper-efficient global supply
chains entails localized, costly factory reconstruction (reshoring) with massive capital demands and structural inflationary baselines.
The โNew Normalโ For Fixed Income
If the neutral rate really is permanently higher, then there are important implications for investors seeking yield. A 3.5%-4% neutral rate would make it much harder for the Federal Reserve to cut rates in the face of a typical recession. By virtue of the fact that the 2010s were such an outlier period for monetary policy, the new normal is not nearly as generous to borrowers and savers. The easy money paradigm is over.
Works Cited
Horn, Taylor N., & Zaman, Saeed. (2025). Neutral Interest Rates and the Monetary Policy Stance. Federal Reserve Bank of Cleveland, Economic Commentary.
St. Louis Federal Reserve. (2026). Comparing the FOMCโs Estimate of R-Star with Alternative Estimates.
PIMCO. (2026). Rupture and Resilience: 2026 Global Economic Outlook.