Natural Rate of Interest
The natural rate of interest (r*) is the theoretical real short-term interest rate consistent with an economy operating at full employment and stable inflation over the medium term, where monetary policy is neither accommodative nor restrictive. It is an unobservable equilibrium concept that central banks use as a benchmark for calibrating policy.
Key takeaways
- The natural rate is a latent variable — it cannot be directly observed and must be estimated using models.
- Secular trends such as demographic aging, productivity slowdown, and high savings rates have pushed r* lower over recent decades.
- When the actual real rate is below r*, monetary policy is stimulative; above r*, it is contractionary.
- The Taylor Rule uses r* as a key input to prescribe the appropriate nominal policy rate.
- Divergence in natural rates across countries influences exchange rate dynamics and cross-border capital flows.
Explanation
The concept of a natural rate of interest was first articulated by Swedish economist Knut Wicksell in 1898, who described it as the rate of return on real capital — the rate at which investment demand equals the supply of loanable funds without inflationary or deflationary pressure. In modern macroeconomic parlance, r* is the real rate that would prevail once all cyclical disturbances have dissipated and the economy is in a neutral steady state.
Estimating r* is technically challenging because it is unobservable. The most influential methodology was developed by Thomas Laubach and John Williams (2003), who use a Kalman filter applied to a small structural model linking output, inflation, and interest rates. Their estimates for the United States fell from approximately 3.5% in the 1980s to near 0% by 2020, a structural decline attributed to lower trend productivity growth, demographic headwinds (aging populations saving more), rising global savings gluts, and a systematic decline in the relative price of capital goods.
For monetary policymakers, r* serves as the fulcrum of the Taylor Rule. If the Federal Reserve sets the federal funds rate such that the real rate equals r*, monetary policy is neutral — neither stimulating nor restraining aggregate demand. Prolonged periods of policy rates below r* generate asset price inflation, excessive credit creation, and eventually inflationary pressure. Conversely, rates persistently above r* risk unnecessary recessions and disinflationary spirals.
In global macro investing, the natural rate framework is indispensable for positioning across fixed income markets and currencies. When a country's r* declines — because of deteriorating demographic trends or productivity — its equilibrium currency tends to depreciate over the long run as capital seeks higher returns elsewhere. Hedge funds tracking this framework pay particular attention to divergences in r* estimates between major economies (e.g., the U.S. versus Japan or Europe) as a source of medium-term currency and rate spread trades.
The post-2022 inflationary episode sparked considerable academic debate about whether r* had risen. Researchers including Holston, Laubach, and Williams updated their model in 2023 to suggest a modest upward revision in U.S. r* estimates, potentially toward 0.5–1.0% in real terms. This shift has profound implications for the terminal fed funds rate, long-run equilibrium Treasury yields, and equity discount rates.
Formula
r* = Real rate consistent with full employment and stable inflation; Nominal neutral rate = r* + π* (where π* is the inflation target)
Example
Assume the Laubach-Williams model estimates r* for the U.S. at 0.5% in real terms, and the Federal Reserve's inflation target is 2%. The neutral nominal rate implied by the Fisher equation is approximately 2.5% (0.5% + 2.0%). If the Fed sets the federal funds rate at 5.25% in 2023 while core PCE inflation is running at 3.5%, the real policy rate is approximately 1.75% (5.25% − 3.5%), which is 1.25 percentage points above r*. A global macro fund would interpret this as significantly restrictive monetary policy likely to slow growth and would position for eventual rate cuts — going long on 2-year Treasury notes and short the U.S. dollar against currencies of economies whose policy rates sit closer to their own r*.
Related terms
Contagion Emerging Markets Equity Exchange Rate Federal Funds Rate Global Macro Inflation Interest Rate Macro Fund Monetary Policy Taylor Rule