Economic neutral rate

What Is the Economic Neutral Rate?

The Economic Neutral Rate, often referred to as the neutral interest rate, is a theoretical interest rate level at which monetary policy is neither expansionary nor contractionary. It represents the rate that is consistent with full employment, stable inflation at a central bank's target, and an economy operating at its full potential, without creating inflationary pressures or deflationary gaps. This concept is a crucial element within macroeconomics and significantly influences central banks' approaches to monetary policy.

The Economic Neutral Rate is a key benchmark for policymakers, indicating the appropriate stance for short-term interest rates. When the actual policy rate, such as the federal funds rate in the United States, is below the economic neutral rate, monetary policy is considered accommodative, stimulating economic growth. Conversely, if the policy rate is above the neutral rate, it suggests a restrictive stance designed to cool down an overheating economy.

History and Origin

The concept of a natural or neutral rate of interest has roots in the work of Swedish economist Knut Wicksell in the late 19th and early 20th centuries, who introduced the idea of a "natural rate" of interest that equilibrates the supply and demand for real capital. This theoretical rate was distinct from the market rate of interest. In modern macroeconomics, the Economic Neutral Rate has evolved to become a core input in policy frameworks, particularly in the context of inflation targeting by central banks.

Over recent decades, there has been a notable decline in estimates of the economic neutral rate across major economies. This decline is attributed to various structural factors, including slower population growth, reduced productivity gains, and a higher global propensity to save. For instance, research by the Federal Reserve Bank of San Francisco highlighted that the neutral real rate, which is the inflation-adjusted neutral rate, decreased by approximately 2 percentage points over the 15 years leading up to 2016.⁹, ¹⁰ This trend has significant implications for how central banks conduct monetary policy in an environment where nominal interest rates are persistently low.

Key Takeaways

• The Economic Neutral Rate is a theoretical interest rate that balances an economy at full employment and stable inflation.
• It serves as a critical benchmark for central banks to gauge the appropriate stance of monetary policy.
• Estimates of the neutral rate have declined over recent decades due to structural economic changes.
• When the policy rate is below the neutral rate, monetary policy is considered stimulative; when above, it is restrictive.
• The neutral rate is unobservable and must be estimated, leading to inherent uncertainties in its application.

Formula and Calculation

The Economic Neutral Rate is not directly observable and must be estimated using economic models and empirical analysis. While there is no single, universally accepted formula, it is generally conceptualized as the sum of the long-run expected inflation rate and the neutral real interest rate (often denoted as r-star or (r^*)).

The relationship can be broadly expressed as:

Where:

• (R_t^n) = The Economic Neutral Rate (nominal)
• (\pi^e) = Long-run expected inflation rate
• (r^*) = The neutral real interest rate (the real interest rate consistent with output at its potential and stable inflation)

Economic models, such as dynamic stochastic general equilibrium (DSGE) models or more simplified statistical approaches like those developed by Laubach and Williams (2003), are used to estimate (r^*). These models often incorporate variables like potential GDP growth, demographic trends, and global capital flows. The Federal Reserve Board, for example, has published estimates of the long-term neutral rate of interest based on various macroeconomic relationships, including how real interest rates affect the output gap.⁸

Interpreting the Economic Neutral Rate

Interpreting the Economic Neutral Rate involves comparing it to the prevailing nominal interest rate set by a central bank. If the central bank's target rate (e.g., the federal funds rate) is significantly below the estimated Economic Neutral Rate, it implies that monetary policy is highly accommodative, encouraging borrowing and investment to stimulate the economy. This stance is typically adopted during periods of economic weakness or low inflation.

Conversely, if the policy rate is set above the Economic Neutral Rate, it signifies a restrictive monetary policy. This aims to curb excessive demand, prevent overheating, and bring down inflationary pressures. The challenge in interpretation lies in the fact that the neutral rate is not constant; it fluctuates over time due to structural economic shifts and is subject to considerable uncertainty in its estimation. Policymakers must continually assess various economic indicators and models to approximate its level.⁷

Hypothetical Example

Imagine a hypothetical economy, "Prosperityland," where the central bank aims for 2% inflation and consistent, stable economic growth. Economists at Prosperityland's central bank estimate the neutral real interest rate ((r^*)) to be 0.5% after accounting for productivity growth and demographic trends.

Using the formula for the Economic Neutral Rate:
(R_t^n = \pi^e + r^*)
If the central bank's inflation target is 2%, then the long-run expected inflation rate (\pi^e) is 2%.

Therefore, the estimated Economic Neutral Rate for Prosperityland is:
(R_t^n = 2% + 0.5% = 2.5%)

Now, consider two scenarios:

1. Stimulative Policy: If Prosperityland's central bank sets its policy rate (e.g., the equivalent of a federal funds rate) at 1.0%, which is below the 2.5% Economic Neutral Rate, this indicates a stimulative policy. The lower real borrowing costs are designed to encourage businesses to invest and consumers to spend, boosting aggregate supply and demand.
2. Restrictive Policy: If the central bank, concerned about rising inflation, raises its policy rate to 3.5%, this rate is above the 2.5% Economic Neutral Rate. This restrictive stance aims to cool the economy by making borrowing more expensive, thereby moderating demand and inflationary pressures.

Practical Applications

The Economic Neutral Rate is a cornerstone in the formulation of monetary policy by central banks worldwide. It provides a conceptual guide for setting policy interest rates to achieve macroeconomic objectives, such as price stability and maximum sustainable employment. Understanding its level helps policymakers determine whether current policy is stimulative, neutral, or restrictive.

Central bankers often refer to the neutral rate when discussing the long-term outlook for interest rates and the implications for monetary policy normalization. For example, the Federal Open Market Committee (FOMC) frequently discusses changes in the Economic Neutral Rate, as a significant decline in this rate can constrain a central bank's ability to stimulate the economy, especially when short-term rates approach the zero lower bound.⁶

Beyond central banking, the Economic Neutral Rate is relevant for:

• Financial Market Analysis: Investors and analysts consider the neutral rate in forecasting long-term bond yields and assessing the sustainability of economic expansions.
• Fiscal Policy Discussions: Governments implicitly consider the neutral rate when evaluating the long-term cost of public debt and the impact of their spending policies.
• Economic Cycles Forecasting: Economists use estimates of the neutral rate to understand underlying economic trends and predict the future path of inflation and output.
• International Economic Coordination: Institutions like the International Monetary Fund (IMF) analyze neutral rates across countries to understand global financial conditions and potential spillover effects. For instance, the IMF has published analyses on the neutral interest rate in the Euro Area, highlighting its importance for regional monetary policy.

Limitations and Criticisms

Despite its importance, the Economic Neutral Rate faces several limitations and criticisms:

• Unobservability: The most significant drawback is that the Economic Neutral Rate is a theoretical construct and cannot be directly observed or measured. It must be estimated using complex economic models, and these estimates can vary significantly depending on the model, data, and assumptions used. This inherent uncertainty makes it challenging for policymakers to rely on it precisely.⁵
• Time-Varying Nature: The neutral rate is not static; it changes over time due to shifts in fundamental economic factors like productivity growth, demographics, and global saving and investment patterns. Accurately tracking these changes in real-time is difficult. The decline in the neutral rate in recent decades has presented a challenge for traditional monetary policy.³, ⁴
• Model Dependence: The estimates of the neutral rate are highly dependent on the specific macroeconomic model employed. Different models can yield different estimates, leading to debates among economists and policymakers about the true level of the rate.
• Data Revisions: The inputs used to estimate the neutral rate, such as potential GDP and inflation expectations, are themselves subject to data revisions, further complicating precise measurement.
• Policy Implications: Over-reliance on an inaccurate estimate of the neutral rate could lead to policy errors, either by keeping policy too tight (leading to disinflation or recession) or too loose (leading to excessive inflation or asset bubbles).

Economic Neutral Rate vs. Natural Rate of Interest

While often used interchangeably, the terms "Economic Neutral Rate" and "Natural Rate of Interest" are closely related but can have subtle distinctions depending on the context.

The Natural Rate of Interest, originally conceived by Knut Wicksell, is a theoretical real interest rate consistent with savings and investment being in equilibrium at full employment without changing the price level. It focuses on the real (inflation-adjusted) rate.

The Economic Neutral Rate, as commonly used today in central banking discussions, often refers to the nominal interest rate that is consistent with an economy operating at its potential, with stable inflation at the central bank's target. Therefore, it typically includes an inflation component. In many modern discussions, the Economic Neutral Rate is considered the sum of the natural real rate of interest (r-star) and the inflation target. Confusion can arise because some economists still use "natural rate of interest" to refer to the broader nominal concept, while others strictly adhere to Wicksell's original real rate definition. Fundamentally, both concepts aim to identify a theoretical equilibrium interest rate that reflects underlying economic fundamentals rather than monetary policy actions.

FAQs

Why is the Economic Neutral Rate important for central banks?

The Economic Neutral Rate is crucial for central banks because it acts as a benchmark to determine the appropriate stance of monetary policy. By comparing the current policy interest rate to the estimated neutral rate, central banks can assess whether their policy is stimulating or restraining the economy and adjust it to achieve goals like stable prices and full employment.

Is the Economic Neutral Rate constant?

No, the Economic Neutral Rate is not constant. It changes over time due to long-term structural factors in the economy. These can include changes in productivity growth, demographics (like an aging population affecting saving and investment), technological advancements, and shifts¹²