The concept of natural interest rate was introduced by the Swedish economist, Knut Wicksell in the late 19th century. When the interest rate goes above its “natural” rate, we would experience inflation and contraction in production. The vise versa would happen if the interest rate goes below the “natural interest rate”.
In a world that is not distorted by monetary policies of central bankers, the natural rate of interest is the rate where forces of supply of capital and demand for it, meet. When the economy is booming, the firms are willing to pay higher rates to investors and the natural rate moves higher, when the economy is declining, the firms are not accepting high rates and the natural rate dwindles.
The concept of natural rate of interest rate is widely adapted in Macroeconomics. Over time a system of naturals has been developed, R-star which is the natural interest rate, the natural unemployment rate and potential gross domestic product, Y-star. These naturals specify the anchors of economic equilibrium, according to modern narration, R-star is a rate that helps an economy sustain full employment and maximum output while keeping the inflation constant.
For years, this system of naturals was a crucial stand point for central bankers to choose the direction of their monetary policy. However, there are growing debate over the credibility of this approach. Anyway, neither R-star nor natural unemployment rate nor Y-star are observable directly.
For example, in the beginning of 2015, the FED economists concluded the R-star was in the negative territory. However, with unemployment declining fast that year, it passed below the natural rate of employment. At the end of 2015, the Economists’ model indicated a positive and high natural interest rate. This rate compelled the FOMC members to stop Quantitative Easing (QE). However, according to the result in the following year, the models were not quite precise and the FOMC decision resulted in a slowdown in output and mini-recessions in the manufacturing sector of the United States.
Most macroeconomic approaches use models and data to estimate natural rates. These models have several parameters, as there is uncertainty over these parameters, they are prone to errors. Recently, Christensen and Mouabbi provide a more robust method to measure natural interest rate. They introduced a financed-based measure of equilibrium real rate. The measure is solely derived from inflation protected bond prices. Also bond-specific premium and real term premium should be calculated cand canceled out of data, the approach is more precise than macroeconomic model specification and tuning. It also provides daily estimation of the evolution of the natural interest rate. Even if the system of naturals is estimated correctly, there is debate over the speed in which the central bankers should respond to it?
Even if the natural interest rate is not a valid guide for monetary policy, it is still of great importance in economics. It indicates whether the public finances are sustainable in the long run or not. The natural interest rate also provides information about economic growth. A low natural rate means firms are reluctant to pay to investors because they do not find lucrative investment projects. The natural interest rates were declining around the globe in the past two decades, the economists attributed this decline to demographics and sluggish productivity growth. However, in the past two years the natural rate was rising, some economists attribute it to the rise of AI, others are still waiting for more clues!
