Natural Rate of Interest
The natural rate of interest is the real interest rate at which saving and investment are in balance at full employment, so that the economy neither overheats nor contracts. The concept, introduced by Knut Wicksell and revived in modern monetary analysis, provides a benchmark for assessing the stance of monetary policy.
Wicksell's Formulation
Wicksell distinguished the natural rate, determined by the real forces of productivity and thrift, from the market rate, set by the banking system and financial conditions. If the market rate is below the natural rate, investment exceeds saving, demand expands, and prices rise. If the market rate is above the natural rate, demand contracts, and prices fall.
The framework implies that price stability requires the market rate to equal the natural rate. Wicksell's analysis linked monetary conditions to price movements through the gap between the two rates, providing an early account of the transmission of monetary policy.
The Modern Natural Rate
In modern analysis, the natural rate, sometimes called the equilibrium real rate or r-star, is the real rate consistent with output at its potential and stable inflation. It is not directly observable and must be estimated, typically from models that relate interest rates to growth and to saving and investment behaviour.
Estimates suggest that the natural rate has declined in many advanced economies over recent decades, reflecting slower productivity growth, demographic change, and shifts in global saving and investment. The decline implies that monetary policy faces a lower effective lower bound, complicating the task of providing stimulus in recessions.
Policy Implications
The gap between the policy rate and the natural rate indicates the stance of monetary policy. If the policy rate is below the natural rate, policy is accommodative; if above, it is restrictive. This framework is used to assess whether policy is appropriately calibrated to economic conditions.
A low natural rate constrains conventional monetary policy, because the policy rate cannot fall far below zero. This constraint has motivated the use of unconventional tools, including quantitative easing and forward guidance, and has prompted debate about the adequacy of the monetary framework.
Determinants and Measurement
The natural rate depends on the factors that determine saving and investment, including productivity growth, demographics, fiscal policy, and global capital flows. Estimates are model-dependent and subject to considerable uncertainty, which complicates their use in policy.
Despite measurement difficulties, the concept provides a useful organising framework for thinking about the stance of policy and about the constraints facing central banks. It also informs the analysis of the interaction between monetary and fiscal policy, particularly when the natural rate is low.
Measurement Approaches
The natural rate is not observable and must be estimated. Approaches include the use of macroeconomic models, in which the natural rate is the real rate consistent with output at potential and stable inflation, and the use of financial data, in which the natural rate is inferred from the yields on inflation-indexed bonds and expected growth.
Estimates vary widely and are subject to substantial uncertainty, reflecting differences in models and in the data used. The uncertainty complicates the use of the natural rate in policy, since the assessment of the policy stance depends on the estimate.
Secular Stagnation
The concept of secular stagnation, associated with Alvin Hansen and revived by Lawrence Summers, holds that the natural rate has fallen persistently below the level needed for full employment, so that desired saving exceeds desired investment at any positive interest rate. The result is chronic deficiency of demand and a tendency toward slow growth and low inflation.
The hypothesis attributes the decline in the natural rate to slower productivity growth, demographic change, rising inequality, and a global saving glut. It implies that monetary policy alone may be insufficient to restore full employment and that fiscal policy has a larger role, particularly in financing investment that raises the natural rate.
The Zero Lower Bound
A low natural rate increases the likelihood that the policy rate will encounter the zero lower bound, the constraint that nominal interest rates cannot fall much below zero. When the natural rate is negative, the central bank cannot set the policy rate low enough to restore full employment, and the economy may stagnate.
The constraint has prompted the use of unconventional monetary policy, including asset purchases and forward guidance, and has motivated proposals for other measures, such as raising the inflation target or using fiscal policy more actively. The analysis of the zero lower bound and of the natural rate therefore informs the design of the monetary and fiscal framework.
Policy Implications
The level of the natural rate affects the assessment of the policy stance and the design of policy. A low natural rate implies that policy must be accommodative for longer to achieve full employment and that the risks of premature tightening are greater. It also implies that the burden of stabilisation may fall more heavily on fiscal policy and on structural reforms that raise the natural rate.
Policies that raise the natural rate include investment in productivity-enhancing capital, measures that increase the supply of safe assets, and reforms that improve the allocation of capital. The identification and implementation of such policies is a central challenge for economies facing low equilibrium interest rates.