The natural rate of interest

The natural rate of interest is the interest rate consistent with maintaining economic growth at its trend rate and stable inflation.

Another definition of the natural rate of interest is:

“the real interest rate consistent with real GDP equalling its potential level (potential GDP) in the absence of transitory shocks to demand. (FR)

In other words the natural rate of interest is that interest rate which causes neither overheating (boom) or lack of demand (recession). Monetary policy is essentially concerned with finding the natural rate – because that will give the best economic outcome of low inflation and economic growth.

Other terms for the natural rate of interest

  • Neutral rate – Austrian economics sometimes refer to it as the neutral rate of interest rates because it is the rate which will avoids asset bubbles / speculation.
  • Equilibrium real interest rate – because it is the rate of interest rate which keeps the economy in equilibrium
  • Wicksellian interest rate – because the Swedish economist Knut Wicksell did a lot of work  (1936) on the idea of a natural rate of interest rate. Wicksell defined the natural rate asthat interest rate which is compatible with a stable price level, and stable asset prices

In everyday language people may refer to a ‘normal’ rate of interest rate, though this has scope for some confusion.

Natural rate of interest rate explained

Suppose we have a base rate of 5% and this leads to a situation with a stable inflation rate of 2% and the economy is expanding at 2.5% (which happens to be UK’s long run trend rate). Then the nominal natural rate of interest is 5%. This means the real natural rate is 3%.

Suppose, that there was a demand side shock, which saw a boost to demand and higher inflation.

  • In this case, inflation rises to 4% and economic growth rises to 4%.
  • To reduce inflation, the Central Bank will have to increase interest rates to 7%.
  • This maintains a real interest rate of 3% (7-4).
  • The higher nominal interest rate has the effect of increasing cost of borrowing and reducing aggregate demand.
  • This causes inflation to fall back to the inflation target of 2% and economic growth to 2.5%
  • With inflation back on target, the Central Bank can cut interest rates to 5% again. (Maintaining real interest rates of 3%) – which proves to be the natural rate of interest.

Natural rate of interest rate and interest rate predictions

With this situation, people will come to expect a real interest rate of 3% over the next 5-10 years because it appears, that this is the natural rate of interest for the economy.

Predictions don’t always prove correct

interest rate predictionsSource Natural rate of interest FR SF

This shows that previous predictions of rising interest rates have proved incorrect. Initially people expected the natural rate to return to long-run equilibrium of 2%. But, the financial crisis shows that the natural rate of interest rates is fallen significantly below past trends.

This shows that what the natural rate was in the past is no guarantee for what will happen in future.

Changes in the natural rate of interest rate

In certain economic cycles, the natural rate of interest rate may be fairly stable at around 2-3%. However, there is no guarantee this will remain. There are several factors that could cause a change in the natural rate of interest rate.

  • Cost push inflation. A rise in oil prices / wages will cause cost push inflation, and lower economic growth. To maintain low inflation would require higher real interest rates.
  • Depression. In a liquidity trap, low interest rates may become less effective in boosting demand. Despite low interest rates, firms and consumers may be unable / unwilling to borrow, therefore, low interest rates may be in sufficient to return economy to long-run trend rate of economic growth.

inflation-interest-rates

This graph shows that between Jan 2003 and Jan 2008, there was a real interest rate of around 2-3%. We would say that the natural rate of interest rate was 2-3% in this period. Many would have predicted this real interest rate to continue.

However, the credit crunch and recession of 2008/09, caused interest rates to fall below the inflation rate – causing negative real interest rates. Yet, even negative real interest rates haven’t fully returned the economy to a trend rate of economic growth consistent with reducing negative output gap.

An important feature of secular stagnation is a fall in the natural rate – even to a negative value.

Falling natural interest rate in US

102815krugman1-tmagArticle

Measuring natural rate FR SF

Other factors that could influence natural rate

  • Higher levels of government borrowing. It is possible that higher levels of government borrowing (during period of economic growth) could cause higher interest rates because of crowding out of private sector saving. Though when government borrowing occurs in a recession, this doesn’t tend to occur.
  • Supply side factors. If there are structural problems in the economy (ageing population, declining productivity of capital, less technological innovation), this will have an impact on the long-run trend rate of economic growth. If investment was less attractive, this may reduce natural rate of interest rate because firms are less willing to invest.

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