In the world of central banking, there are several key factors that influence monetary policy decisions. One of the most important is the relationship between the real interest rate (R*) and policy rates. In a recent speech, Federal Governor Miran made the observation that if R* is lower, policy rates should be lower. But what exactly does this mean, and how does it impact monetary policy decisions?

To understand the relationship between R* and policy rates, it’s important to first define these terms. The real interest rate (R*) is the interest rate that an economy would need to achieve in order for investment to be at its maximum level. In other words, it’s the rate at which the economy can produce the most output with the available resources. Policy rates, on the other hand, are the interest rates set by central banks to control the money supply and inflation.

So why is Governor Miran suggesting that policy rates should be lower if R* is lower? The key here is that a lower R* means that investment is less expensive in real terms. This means that businesses and individuals are more likely to invest, which can lead to increased economic growth and higher output. By setting policy rates lower, central banks can encourage this investment and help the economy reach its maximum potential.

However, it’s important to note that the relationship between R* and policy rates is not always straightforward. There are several factors that can influence this relationship, including changes in inflation expectations, the level of government debt, and the exchange rate. For example, if inflation expectations are high, central banks may need to raise policy rates even if R* is low in order to combat inflation. Similarly, if government debt levels are high, central banks may need to raise policy rates to reduce the burden on taxpayers.

The relationship between R* and policy rates is complex and multifaceted. Central banks must carefully consider a range of factors when making monetary policy decisions, including the level of investment in the economy and changes in inflation expectations. By understanding this relationship, central banks can more effectively promote economic growth and stability.