What is the Natural Rate of Interest?
The natural rate of interest is also called the neutral interest rate, neutral rate, r* (r-star), and the long-run equilibrium interest rate. This interest rate is the theoretical short-term interest rate that would support the economy at maximum output or full employment GDP while keeping inflation constant. The neutral rate is often referred to by central banks when making decisions about the bank rate since this neutral rate is essentially the dividing line between expansionary and contractionary monetary policy.
Although the usage of this concept dates back to 1898, by Swedish economist, Knut Wicksell, it wasn’t until the 1990s that the natural rate of interest became more widely used by central banks increasing their focus on targeting interest rates.
Quick Summary of Points
- The natural or neutral rate of interest is the short-term interest rate that would, theoretically, support the economy at full employment GDP while keeping inflation constant
- Central banks often use this rate when making decisions about monetary policy
- When the market interest rate is below the natural interest rate, prices increase, and when the market interest rate is above the natural rate, prices decrease
- The Laubach-Williams model is one of the most commonly used models to determine the natural rate
Why is the Natural Rate of Interest Important?
The natural rate of interest is very important because of the role that it plays in monetary policy. Depending on what a central bank believes is neutral, it will implement the short-term bank rate accordingly. During times when they believe the economy needs a stimulus, they will set the bank rate below the neutral rate. If the central bank believes the economy needs a cooling-off period, it will set the bank rate above the neutral rate.
A monetary policy move such as a central bank’s decision to increase or decrease short term interest rates can have significant effects on the economy. This decision may affect inflation, unemployment, exchange rates, and the GDP growth of a country. Due to the importance of setting interest rates, understanding where the neutral rate lies is vital to making effective policy decisions. These decisions are so impactful that a central bank weighing in with its opinion of where the current bank rate lies in relation to the neutral rate is an indicator that they may soon consider changing the bank rate. Just knowing the central bank’s stance on the neutral rate can lead to market rallies or sell-offs.
Natural Rate of Interest vs Market Rate of Interest
In Wicksell’s theory about the natural rate of interest, the most important thing to consider is the difference between this rate and the market rate of interest. Based on whether the market interest rate is above or below the natural interest rate, conclusions can be drawn.
The market interest rate is the actual interest rate that is paid on deposits and investments. This is determined by the supply and demand for funds in the money market and is dependent on the rate the central bank sets.
According to Wicksell, in the short term, the market interest rate and natural rate are often different. When the market interest rate is below the natural rate, the supply of savings is less than the demand for loans. In this scenario, the total demand for money is higher than the supply. Assuming this demand is financed by an expansion in bank loans, this scenario leads to increasing prices.
In the opposite scenario, the market interest rate is above the neutral interest rate. The supply of savings is more than the demand for loans. This will lead to falling prices.
How is the Natural Rate of Interest Determined?
Although this concept is very important, the natural rate is not a number that can be determined with a high level of certainty. This unobservable rate must be inferred based on a number of factors. There will generally be significant disagreement between the different estimates and models used to come to these conclusions. The most common model used to determine the natural interest rate is the Laubach-Williams model.
The Laubach-Williams approach was developed by Federal Reserve economists Thomas Laubach and John Williams. This model assumes a relationship between interest rates and economic activity. It takes a Keynesian approach, where an increase in the real rate should, in theory, lead to a reduction in consumption and investment. The natural rate in this model is calculated by using a Kalman filter and uses data such as GDP growth, inflation, and the central bank rate.
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