European Interest Rates: How Far to R*?

The outlook for the European Central Bank's (ECB) neutral rate, or R*, suggests that it should not significantly exceed pre-pandemic levels. This perspective arises from the belief that recent inflationary pressures, driven by the pandemic, supply chain disruptions, and energy shocks, are largely temporary and have begun to reverse. The ECB is advised to focus on long-term structural factors rather than these short-lived cyclical influences when estimating R*.

Prior to the pandemic, models indicated a downward trend for R*. While some models now suggest a potential rise, the underlying structural conditions in the eurozone have not changed sufficiently to warrant a higher neutral rate. The eurozone is expected to return to pre-pandemic economic conditions, with GDP growth projected to remain below potential, dropping from 1.2% to below 1% by 2028, exacerbated by adverse demographics such as an aging population.

Expansionary fiscal policies may have temporarily elevated R*, but future fiscal constraints will likely reduce this impact. Current market estimates of the ECB's policy rate settling between 1.8% and 1.9% may be too high, as potential growth is expected to slow, fiscal policy stabilizes, and inflation decreases. Consequently, both R* and the conclusion of the ECB's easing cycle might be lower than current forecasts suggest.