Natural Rate of Interest

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 rateInterest RateAn interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal. is the theoretical short-term interest rate that would support the economy at maximum output or full employment GDPGross Domestic Product (GDP)Gross domestic product (GDP) is a standard measure of a country’s economic health and an indicator of its standard of living. Also, GDP can be used to compare the productivity levels between different countries. while keeping inflationInflationInflation is an economic concept that refers to increases in the price level of goods over a set period of time. The rise in the price level signifies that the currency in a given economy loses purchasing power (i.e., less can be bought with the same amount of money). 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 expansionaryExpansionary Monetary PolicyAn expansionary monetary policy is a type of macroeconomic monetary policy that aims to increase the rate of monetary expansion to stimulate the growth of the domestic economy. The economic growth must be supported by additional money supply. and contractionaryContractionary Monetary PolicyA contractionary monetary policy is a type of monetary policy that is intended to reduce the rate of monetary expansion to fight inflation. A rise in inflation is considered the primary indicator of an overheated economy. The policy reduces the money supply in the economy 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.

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 policyMonetary PolicyMonetary policy is an economic policy that manages the size and growth rate of the money supply in an economy. It is a powerful tool to regulate macroeconomic variables such as inflation and unemployment.. 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 stimulusExpansionary Monetary PolicyAn expansionary monetary policy is a type of macroeconomic monetary policy that aims to increase the rate of monetary expansion to stimulate the growth of the domestic economy. The economic growth must be supported by additional money supply., they will set the bank rate below the neutral rate. If the central bank believes the economy needs a cooling-offContractionary Monetary PolicyA contractionary monetary policy is a type of monetary policy that is intended to reduce the rate of monetary expansion to fight inflation. A rise in inflation is considered the primary indicator of an overheated economy. The policy reduces the money supply in the economy 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 ratesInterest RateAn interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal. can have significant effects on the economy. This decision may affect inflationInflationInflation is an economic concept that refers to increases in the price level of goods over a set period of time. The rise in the price level signifies that the currency in a given economy loses purchasing power (i.e., less can be bought with the same amount of money)., unemployment, exchange rates,Foreign ExchangeForeign exchange (Forex or FX) is the conversion of one currency into another at a specific rate known as the foreign exchange rate. The conversion rates for almost all currencies are constantly floating as they are driven by the market forces of supply and demand. and the GDPGross Domestic Product (GDP)Gross domestic product (GDP) is a standard measure of a country’s economic health and an indicator of its standard of living. Also, GDP can be used to compare the productivity levels between different countries. 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 ralliesRallyA rally refers to a period of continuous increase in the prices of stocks, indexes or bonds. The word rally is typically used as a buzzword by business media outlets such as Bloomberg to describe a period of increasing prices. 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 rateInterest RateAn interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal. that is paid on deposits and investments. This is determined by the supply and demand for funds in the money marketMoney MarketThe money market is an organized exchange market where participants can lend and borrow short-term, high-quality debt securities with average maturities of one year or less. 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 rateInterest RateAn interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal. 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 KeynesianKeynesian Economic TheoryKeynesian Economic Theory is an economic school of thought that broadly states that government intervention is needed to help economies emerge out of recession. The idea comes from the boom-and-bust economic cycles that can be expected from free-market economies and positions the government as a "counterweight" 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.

Additional Resources

Thank you for reading this CFI article on central bank interest rate policies. If you would like to learn about related concepts check out CFI’s other resources listed below:

• Interest RateInterest RateAn interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal.
• Keynesian EconomicsKeynesian Economic TheoryKeynesian Economic Theory is an economic school of thought that broadly states that government intervention is needed to help economies emerge out of recession. The idea comes from the boom-and-bust economic cycles that can be expected from free-market economies and positions the government as a "counterweight"
• Monetary PolicyMonetary PolicyMonetary policy is an economic policy that manages the size and growth rate of the money supply in an economy. It is a powerful tool to regulate macroeconomic variables such as inflation and unemployment.
• InflationInflationInflation is an economic concept that refers to increases in the price level of goods over a set period of time. The rise in the price level signifies that the currency in a given economy loses purchasing power (i.e., less can be bought with the same amount of money).