Introduction to the Natural Rate of Interest
The concept of the natural rate of interest, often referred to as "r*", has become a central theme in monetary policy debates. It is defined as the real interest rate that is consistent with stable inflation and output at its potential level. However, the natural rate of interest is not directly observable and must be estimated using various models and statistical techniques.
The Evolution of the Natural Rate of Interest
The modern use of the natural rate of interest can be traced back to the work of Knut Wicksell, a Swedish economist. However, its operational role expanded significantly with the advent of inflation targeting and semi-structural macroeconomic models. Central banks, such as the Federal Reserve and the European Central Bank, routinely reference r* estimates to assess the stance of policy.
The Problem with the Natural Rate of Interest
The natural rate of interest is estimated using variants of the Laubach-Williams framework, which infers r from observed data on output, inflation, and interest rates. However, this approach assumes that r moves slowly and reflects deep structural forces, such as productivity growth, demographics, or preferences. This assumption is no longer convincing, as r* has shifted from a theoretical reference point to a central operational benchmark.
Why the Natural Rate of Interest has Become a Belief
Three structural forces explain why the natural rate of interest now behaves less like a number and more like a belief. First, financial markets internalize policy narratives, interpreting r estimates as signals of central bank intent. Second, r estimates are regime-dependent, relying on assumptions about trend productivity, labor market slack, and potential output. Third, policy feeds back into estimation, as central banks tighten or loosen policy based on r* estimates, which in turn affect investment, productivity growth, and potential output.
The Impact of Algorithmic Systems
Recent advances in artificial intelligence have intensified the dynamic, as economic expectations are shaped by algorithmic systems that generate real-time forecasts, scenario analyses, and portfolio recommendations. These systems do not weigh intent or nuance, extracting signals, correlations, and point estimates and acting on them at machine speed. As a result, r* estimates risk becoming operational facts simply because algorithms require a number, not because the economy has revealed one.
The Consequences of the Natural Rate of Interest as a Belief
The natural rate of interest has become a belief-coordination device, aligning expectations across central banks, markets, and algorithmic systems. This has significant implications for business leaders and investors, as monetary "restrictiveness" is no longer a mechanical comparison between the policy rate and a fixed benchmark. Instead, it is a judgment contingent on how central banks interpret r* and how markets and algorithms respond to that interpretation.
Conclusion
In conclusion, while the natural rate of interest has not lost relevance, it no longer functions as a stable, policy-invariant parameter waiting to be discovered. Rather, it has become a convention with real consequences, shaped by narratives, model conventions, and institutional priors. Recognizing this does not weaken monetary policy but makes its limits clearer and its design more urgent. As such, policymakers must be aware of the potential risks and uncertainties associated with the natural rate of interest and develop more robust policy frameworks that are resilient to r* uncertainty.
