What Is the Natural Rate of Interest?
The natural rate of interest, often referred to as r-star (r*), is a theoretical concept representing the real short-term interest rate that would prevail in an economy at full employment with stable inflation. It is a key concept within macroeconomics and monetary policy, serving as a benchmark for central banks to gauge whether their current policy stance is stimulatory or contractionary. This rate is consistent with overall economic activity operating at its sustainable, non-inflationary potential. When the actual real interest rate aligns with the natural rate of interest, the economy is considered to be in equilibrium, with aggregate savings balancing investment demand.
History and Origin
The concept of the natural rate of interest was pioneered by the Swedish economist Knut Wicksell in his 1898 work, Interest and Prices. Wicksell defined it as the interest rate that is compatible with a stable price level. According to Wicksell's theory, if the prevailing market rate of interest falls below the natural rate, it would stimulate excess investment demand relative to available savings, leading to rising prices and inflation through a "cumulative process." Conversely, if the market rate exceeded the natural rate, it would lead to contraction and deflation. Wicksell's insight was that for price stability and real economic equilibrium to hold, the market rate and the natural rate of interest must be equal.9
A century later, the concept experienced a resurgence in modern macroeconomic thought, particularly through the work of economists like Michael Woodford. His contributions connected Wicksell's original idea to New Keynesian frameworks, demonstrating how the natural rate is influenced by fundamental economic factors such as productivity shocks and shifts in consumer preferences.
Key Takeaways
- The natural rate of interest is the theoretical real interest rate consistent with full employment and stable inflation.
- It serves as a crucial benchmark for central banks in setting their monetary policy.
- First introduced by Knut Wicksell, the concept has evolved but remains central to understanding macroeconomic equilibrium.
- The natural rate is unobservable and must be estimated, leading to variations in its calculated value across different models and institutions.
- Deviations between the actual real interest rate and the natural rate of interest can signal inflationary or deflationary pressures.
Formula and Calculation
The natural rate of interest is not directly observable or calculated using a simple, universally agreed-upon formula. Instead, it is an estimated theoretical construct derived from complex macroeconomic models. One widely recognized approach for estimating the natural rate of interest is the Laubach-Williams (LW) model, and its extension, the Holston-Laubach-Williams (HLW) model, developed by economists at the U.S. Federal Reserve. These models use statistical filtering techniques, such as the Kalman filter, to infer the natural rate based on observable data like real gross domestic product, inflation, and the actual short-term interest rate.8
The LW/HLW model often posits a relationship where the natural rate of interest is influenced by the trend rate of potential output growth and other unobserved factors. While there isn't a single formula to "solve" for r*, the models conceptually suggest:
Where:
- (r^*_t) = the natural rate of interest at time (t)
- (c) = an estimated coefficient
- (g^*_t) = the estimated trend economic growth rate of potential output at time (t)
- (z_t) = an unobserved component capturing other influences on the natural rate, assumed to follow a random walk process.
This estimation process continually updates as new economic data becomes available.
Interpreting the Natural Rate of Interest
Interpreting the natural rate of interest is crucial for policymakers and analysts to understand the underlying health of an economy and the appropriate stance of monetary policy. If the actual real interest rate is below the estimated natural rate of interest, it suggests that monetary policy is accommodative, stimulating economic activity and potentially leading to inflationary pressures. Conversely, if the real rate is above the natural rate, monetary policy is considered restrictive, aiming to slow economic growth and curb inflation.
The level of the natural rate also provides insight into long-term economic trends. A declining natural rate may signal structural shifts such as slower productivity growth, aging demographics, or an increased global demand for safe assets. For instance, the natural rate of interest in many advanced economies experienced a significant decline over several decades leading up to the pandemic.7
Hypothetical Example
Consider a hypothetical economy where the estimated natural rate of interest is 2%. This implies that, at a 2% real interest rate, the economy would be operating at full employment with stable inflation.
Scenario 1: The central bank sets its policy rate such that the real interest rate in the economy is 1%. Since 1% is below the natural rate of 2%, this indicates that monetary policy is expansionary. The lower real rate encourages borrowing for investment and consumption, leading to an increase in aggregate demand and potentially pushing inflation above target if sustained.
Scenario 2: The central bank adjusts its policy rate, resulting in a 3% real interest rate. As 3% is above the natural rate of 2%, this signals a contractionary monetary policy stance. Higher borrowing costs discourage new investment and consumer spending, aiming to cool down an overheated economy or bring down elevated inflation. This adjustment helps guide the economy back towards its non-inflationary potential output.
Practical Applications
The natural rate of interest holds significant practical applications, particularly in the realm of monetary policy and broader economic analysis:
- Monetary Policy Guidance: Central banks use estimates of the natural rate of interest as a crucial guidepost for setting their policy interest rates. It helps them assess whether their current stance is appropriate to achieve objectives like price stability and maximum sustainable employment. For instance, economists at the Federal Reserve Bank of New York regularly publish estimates of r-star to inform policy discussions.6
- Assessing Fiscal Space: For fiscal policy, the natural rate is a key determinant of public debt sustainability. A higher natural rate implies higher nominal rates over the long term, which typically means that higher primary surpluses or smaller deficits are required to stabilize debt-to-GDP ratios.5
- Forecasting Economic Trends: Changes in the natural rate of interest can reflect underlying structural shifts in the economy, such as changes in productivity, demographics, or the global supply and demand for savings and investment. Understanding these shifts helps policymakers anticipate future economic challenges and adjust long-term strategies.
Limitations and Criticisms
Despite its theoretical importance, the natural rate of interest faces significant limitations and criticisms, primarily due to its unobservable nature.
One major challenge is that the natural rate of interest cannot be directly measured; it must be estimated using complex models. These estimates are often subject to substantial revisions as new data becomes available, making real-time policy decisions difficult.4 Different models and approaches can yield varying estimates for the natural rate, leading to disagreement among economists and policymakers about its precise level. For example, in 2023, estimates from the Federal Reserve Bank of New York and the Federal Reserve Bank of Richmond differed, highlighting the inherent uncertainty in measurement.3
Critics also argue that the concept can be an "abstract, unobservable, model-dependent concept" that has the "potential of leading policy astray."2 Some heterodox economists reject the very notion of a natural rate, viewing it as a theoretical construct that simplifies complex economic dynamics. There is also debate about whether the natural rate has risen or fallen in the wake of significant global events like the COVID-19 pandemic.1 Furthermore, the natural rate's reliance on assumptions about potential output and trend economic growth, which are themselves difficult to measure accurately, can propagate errors into the natural rate estimates.
Natural Rate of Interest vs. Market Rate of Interest
The distinction between the natural rate of interest and the market rate of interest is fundamental to macroeconomic analysis.
| Feature | Natural Rate of Interest (r*) | Market Rate of Interest |
|---|---|---|
| Definition | The theoretical real interest rate that balances savings and investment when the economy is at full employment with stable inflation. | The actual prevailing interest rate in financial markets, influenced by supply and demand for loanable funds and central banks' policy actions. |
| Observability | Unobservable; must be estimated using complex models. | Directly observable in financial markets (e.g., federal funds rate, bond yields, lending rates). |
| Determinants | Driven by long-term structural factors such as productivity growth, demographics, and risk preferences. | Influenced by monetary policy, investor sentiment, short-term economic conditions, and market liquidity. |
| Policy Role | Serves as a benchmark or target for central banks to guide their policy decisions towards achieving macroeconomic stability. | The rate that central banks directly manipulate (or target) to influence economic activity. |
Confusion often arises because both rates relate to the cost of borrowing or the return on lending. However, the market rate is the rate seen and transacted in daily financial transactions, while the natural rate is a conceptual anchor that policymakers aim to align the market rate with over the long run to avoid inflationary or deflationary pressures and smooth out business cycles.
FAQs
What does it mean if the natural rate of interest is low?
A low natural rate of interest suggests that the fundamental drivers of an economy, such as productivity growth and demographic trends, support a lower equilibrium real interest rate. This can make it more challenging for central banks to stimulate the economy during downturns, as policy interest rates might hit the zero lower bound more frequently.
Why is the natural rate of interest unobservable?
The natural rate of interest is unobservable because it represents a theoretical equilibrium state of the economy that is not directly measurable in real time. It is influenced by underlying structural factors like technological progress, population changes, and preferences for savings and investment, which are constantly evolving and cannot be precisely quantified. Economists use complex statistical models to estimate it based on observable economic data.
How does the natural rate of interest influence monetary policy?
The natural rate of interest acts as a crucial benchmark for monetary policy. Central banks aim to keep the market rate of interest close to the natural rate to achieve their goals of price stability and maximum sustainable employment. If the market rate is too far above or below the natural rate, it can lead to undesired inflation or deflation and economic instability.