Introduction to Central Banks and Interest Rates
When discussing central banks and the outlook for interest rates, economists often refer to the so-called "star" variables. These variables are essential in understanding how the economy works and play a crucial role in central bankers’ decision-making processes. In this article, we will delve into the world of star variables, exploring what they are, why they are important, and how they influence interest-rate decisions.
What are Star Variables?
Star variables are key concepts in economic models used by central bankers to comprehend the economy. They are named as such because they are usually labeled with an asterisk to distinguish them from other variables in economic modeling. Central bankers consider these variables as a "constellation" that links economic growth, the labor market, and interest rates together with inflation outcomes.
The Three North Stars
There are three primary star variables that central bankers focus on:
- *Potential Output (y)**: This refers to the economy’s maximum sustainable output that can be produced when all resources are fully employed. It is often referred to as the economy’s speed limit. If economic growth exceeds potential output, it can put upward pressure on inflation because demand for goods and services outstrips supply.
- *Non-Accelerating Inflation Rate of Unemployment (NAIRU) or (u)**: This concept, popularized in the 1970s, suggests that there is a "natural" rate of unemployment that does not put pressure on wages or inflation.
- *The Neutral Interest Rate (r)**: This is considered to be the level of the central bank’s key interest rate that is not too low (and stimulating demand) and not too high (and restraining demand). It serves as a useful guide to the stance of the central bank’s monetary policy.
Good in Theory, Hard to Measure in Practice
These three interlinked variables are fundamental to how central bankers think about the economy. However, they are concepts that are not directly observable, unlike published statistics on inflation or economic growth. As a result, central bankers must use statistical methods to estimate them, which can be challenging.
The Challenges of Estimation
Estimating star variables is a complex task, and central bankers must use techniques originally developed to track spacecraft to detect their effects on other observable variables, such as inflation, wages growth, and the unemployment rate. This uncertainty is a significant challenge for central bankers, making it difficult for them to know exactly what decision they should make to achieve their objectives.
How the Variables Help with Setting Interest Rates
Most central banks aim to maintain price stability (low and stable inflation). Some, like the Reserve Bank of Australia and the US Federal Reserve, have dual mandates to maintain price stability and full employment. The star variables play a crucial role in helping central bankers achieve these objectives.
Setting Inflation Targets
Specifying a target for inflation is seen as the best way to achieve price stability. The Reserve Bank’s target, for example, is 2-3% over the economic cycle. Over time, inflation tends to be steady when the unemployment rate is close to the NAIRU. As a result, central bankers often use the NAIRU as a rough guide to full employment, which is also broadly consistent with the economy operating near potential.
Conclusion
In conclusion, star variables are essential concepts in understanding how central banks make decisions about interest rates. While they are challenging to measure, they play a critical role in helping central bankers achieve their objectives of maintaining price stability and full employment. By understanding these variables, we can gain insight into the complex decision-making processes of central banks and how they aim to promote economic growth and stability. Despite the uncertainties involved, central bankers must carefully consider the star variables to make informed decisions about interest rates, which have a significant impact on the economy.
