What Is the Natural Rate of Interest?
The natural rate of interest, also called the neutral or equilibrium interest rate, refers to the real interest rate that supports full employment and stable inflation in an economy. It is neither expansionary nor contractionary. The Federal Reserve and other central banks use it as a benchmark to determine monetary policy.
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Why Does the Natural Rate of Interest Matter?
Understanding the natural rate is important for making sense of monetary policy. If the Federal Reserve sets interest rates below the natural rate, borrowing increases, and inflation can rise. If rates stay above the natural rate, economic growth slows, and unemployment can increase.
Key Factors Affecting the Natural Rate
Several factors influence the natural rate of interest:
- Productivity Growth: Higher productivity leads to greater economic output and a higher natural rate.
- Demographics: An aging population tends to lower the natural rate, while a younger, growing workforce can increase it.
- Global Capital Flows: Inflows of foreign investment can push the natural rate down, while capital outflows can raise it.
- Government Debt Levels: High government borrowing can raise the natural rate as the demand for funds increases.
- Inflation Expectations: If inflation expectations rise, lenders demand higher interest rates to compensate for the declining purchasing power of money.
How to Calculate the Natural Rate of Interest
Economists use different models to estimate the natural rate. One common method is the Laubach-Williams model, which uses GDP growth and inflation expectations to estimate the natural rate.
A simplified formula for estimating the real natural rate is:
r^* = g + pWhere:
- r^* is the natural rate of interest
- g is the long-term real GDP growth rate
- p is the long-term inflation rate
For example, if long-term GDP growth is 2% and inflation is expected to be 2%, then:
r^* = 2% + 2% = 4%This means the natural nominal interest rate should be around 4%.
Comparing the Natural Rate to Market Interest Rates
The market interest rate (such as the federal funds rate) may differ from the natural rate due to monetary policy actions. The relationship between the two determines whether monetary policy is expansionary or contractionary.
| Condition | Market Rate vs. Natural Rate | Economic Effect |
|---|---|---|
| Expansionary Policy | Market rate < Natural rate | Increased borrowing, inflation risk |
| Contractionary Policy | Market rate > Natural rate | Slower growth, higher unemployment |
| Neutral Policy | Market rate = Natural rate | Economic stability |
Historical Trends in the US Natural Rate of Interest
Over the past several decades, the natural rate has declined. In the 1980s, estimates of the natural rate were around 4-5%, but today they are closer to 0-2%.
| Decade | Estimated Natural Rate (%) |
|---|---|
| 1980s | 4.5% |
| 1990s | 3.5% |
| 2000s | 2.5% |
| 2010s | 1.5% |
| 2020s | 0.5% – 2% |
The main reasons for this decline include lower productivity growth, aging demographics, and increased global savings.
Real-World Examples of the Natural Rate’s Impact
Example 1: The 2008 Financial Crisis
Following the Great Recession, the Federal Reserve lowered interest rates to near zero. However, economic growth remained slow, suggesting that the natural rate had also fallen. If policymakers had assumed a higher natural rate, they might have tightened monetary policy too soon, leading to a prolonged slowdown.
Example 2: The COVID-19 Pandemic
During the pandemic, the Federal Reserve cut interest rates to support the economy. Inflation later surged, leading to aggressive rate hikes. This shows the challenge of estimating the natural rate in real time—setting rates too low for too long can create inflationary pressures.
Policy Implications
Understanding the natural rate helps policymakers avoid major economic mistakes. If they overestimate the natural rate, they risk keeping interest rates too high, stifling economic growth. If they underestimate it, they may keep rates too low, causing inflation.
Conclusion
The natural rate of interest is a crucial economic concept that guides monetary policy. While it cannot be observed directly, economists estimate it based on factors like productivity, demographics, and inflation expectations. Understanding how it works helps us interpret interest rate decisions and their effects on the economy.
