The article first appeared on OMFIF on Feb 13th, 2025

Joachim Nagel is President of Deutsche Bundesbank.

Natural rate of interest provides useful framework for policy-makers

When astronomers observe the stars, impressive images can come into view. When economists talk about stars, it usually gets complicated. The natural rate of interest – also known as r-star – is a concept that economists have been grappling with for more than 125 years. And it has perhaps never received more attention than in the current era of monetary policy.

Let’s start with the definition. The natural rate is the real interest rate that would prevail if the economy were operating at its potential and prices were stable. R-star is commonly thought to be driven by real forces that structurally affect the balance between saving and investment. This also means that r-star should, by definition, be independent of monetary policy.

At first glance, the natural rate could be a guiding star for the conduct of monetary policy. If a central bank sets its policy rates so that the real interest rate is above r-star, monetary policy is restrictive or ‘tight’. Consequently, economic activity slows and the inflation rate should decrease.

If the real rate is below r-star, monetary policy is expansionary or ‘loose’. It provides incentives for consumers to purchase more and for enterprises to step up investment and output. This should result in more economic activity and a higher inflation rate.

However, the idea of the natural rate serving as a guiding star for monetary policy comes with profound challenges.

Uncertainties around r-star estimates

Estimates of the natural rate of interest are subject to major uncertainties, shaped by three Ms: megatrends, methodology and monetary policy.

First, we are facing a number of megatrends. Think of climate change, ageing societies, digitalisation and the risks of de-globalisation and increasing geopolitical divisions. The effects of these megatrends on natural rates are difficult to gauge and may change over time.

On the one hand, they could contribute to a higher natural rate. The widespread uptake of artificial intelligence could boost productivity growth. The green transition could lead to higher investment. Fiscal deficits could persist at an elevated level due to higher defence spending given geopolitical tensions. The entry of the baby boomer generation into retirement could reduce savings.

On the other hand, life expectancy is predicted to keep rising, the high hopes for the productivity-enhancing effect of AI could turn out to be too optimistic and, given high public debt levels, fiscal space for additional spending is limited in many countries. Overall, it is virtually impossible to predict which developments will prevail in affecting r-star.

The second factor of uncertainty is methodology. The methods used to define and estimate r-star differ in important ways, especially in terms of time and risk.

Third, monetary policy itself may play a role in shaping the natural rate or its estimates. A number of studies challenge the view that money is neutral in the long run.

There are different channels through which monetary policy could have lasting effects on real interest rates. Prolonged tight monetary policy, for example, may lower investment, innovation and productivity growth. By contrast, persistent monetary easing could fuel financial imbalances and contribute to zombification.

Conclusions for monetary policy

What role can and should r-star play for monetary policy in practice?

Put yourself in the shoes of a monetary policy-maker who only looks at r-star. The relevant interest rate with which you steer the monetary policy stance is currently 2.75%. After a previous series of interest rate cuts, you consider whether a further cut would be appropriate.

Your staff inform you that various point estimates of r-star range from around 1.8% to 2.5% in nominal terms. If r-star were at the upper end of the estimates, the policy rate would become neutral with the next rate cut. Things would be different if r-star were at the lower end of the estimates: monetary policy would continue to be restrictive, even after several further rate cuts.

So how would you proceed, given a certain stance you want to achieve? Beware: if you rely on a wrong estimate, your decision may have a different effect on inflation than you intended. Simply choosing the middle of the range might not be a happy medium. Around the point estimates, there are often uncertainty bands of different sizes and with asymmetries.

As you have probably guessed:it is no coincidence that I have described this particular decision-making situation. It looks similar in the euro area ahead of the next monetary policy meeting of the European Central Bank Governing Council at the beginning of March. After several rate cuts, the neutral rate could already be near – or there may still be some way to go.

The president of the Federal Reserve Bank of New York, John Williams, put the problem in a nutshell when he said: ‘as we have gotten closer to the range of estimates of neutral, what appeared to be a bright point of light is really a fuzzy blur’.

The bottom line here is this: the closer we get to the neutral rate, the more appropriate it becomes to take a gradual approach. For this purpose, r-star is a helpful concept: it indicates when we need to be more cautious with policy rate moves so that we don’t take a wrong step.

At the same time, the limits of the concept are also clear: it would be risky to base decisions mainly on r-star estimates. Much more is needed to assess the current monetary policy stance and the optimal policy path for the near future.

That is why the Eurosystem uses a variety of financial, real economic and other indicators along the monetary policy transmission mechanism. We want the fullest picture possible. And, of course, r-star also has a place in this picture.

In my opinion, proceeding in a data-driven and gradual manner has served the ECB Governing Council well. There is no reason to act hastily in the present uncertain environment. The data will tell us where we need to go.

Away from day-to-day monetary policy-making, the concept of the natural rate of interest provides a useful framework. It is important to understand the forces that are shifting real interest rate trends. We need to find out how these forces and trends affect our work to ensure price stability.

Reviewing our monetary policy strategy from time to time is therefore vital. That is precisely what we are doing right now in the Eurosystem.