Download Natural Rate of Interest

Key Interest Rate in the Long Run
One of the hot topics at the recent Federal Reserve conference at Jackson Hole was the natural
rate of interest. What is natural rate and why does it matter to the central bank like Federal
Reserve and the Bank of Korea?
Suppose the economy is at full employment and the inflation rate is steady near the central
bank’s target. Let’s further assume that there is no economic shock like the subprime mortgage
crisis or the plunge in the price of oil. In this situation, the supply and demand factors in the
credit market would produce an interest rate called, the “natural rate (after subtracting
inflation).” In the long run, this is the target interest rate a central bank should target.
How does one find out what the natural rate is? Potential GDP growth along with long-term
inflation expectation are some of the variables determining the natural rate. Potential GDP
comes from two primary sources: the growth of labor force and the productivity of the labor
force. For most developed economies including the U.S., low fertility rate has been sapping
labor force growth rate. Productivity growth has been slowing as investments and new
innovations have been limited. For these reasons, potential GDP growth has been trending
down for the U.S. economy. The U.S. government estimates that the potential is about 1.5
percent hopefully approaching 2 percent in the long run.
In addition to the potential economic growth rate, inflation expectation in the long-run is
important in estimating the natural rate. The inflation target is 2 percent for the Federal
Reserve. To the dismay of the central bankers, however, the inflation rates among developed
nations have been languishing closer to zero. Some economies like Japan are very concerned
about deflation resorting to negative interest rates. It is highly unlikely that the actual inflation
rate and the inflation expectation would rise significantly in the foreseeable future.
Based on these considerations, the natural rate is calculated. In the U.S, the natural interest
rate is close to zero today.
Estimates of the natural rate is important because it is a guide in setting the key interest rate
(without inflation) by the central bank. If the real key interest rate is set too high relative to the
natural rate for an extended period, economic growth could fall below the potential growth
rate and the inflation rate could undershoot. If the key interest rate is set too low for an
extended period, the inflation rate could surge and a bubble in the economy could result.
For example, the real key interest rates in the U.S. was too low relative to the natural rate
between 2001 and 2006 leading to the bubble in house prices and the subprime mortgage
debacle.
With the natural rate close to zero, the current interest rates set by the central bank are not as
stimulative as one thinks. This also means that there is not much room for the key interest rate
to go up in the future. During previous recessions, the Federal Reserve responded by cutting
the key interest rate by 3 to 4 percentage points because the natural rate was relatively high. In
the next economic downturn, the central bank won’t have much ammunition left since the
natural rate is already so low not too far above the lower bound of zero.
Under the circumstances, non-conventional monetary policies like Quantitative Easing (QE) and
negative interest rate could become more common place in the future.
Is there any way to raise the natural rate of interest rate? A member of the FOMC at the
Federal Reserve has floated the idea of raising the target inflation rate set by the central bank.
For example, the Federal Reserve could raise the inflation target to 4 percent from the current
2 percent. The idea is to raise the inflation expectations in the marketplace boosting the natural
rate. Whether the central bank could manipulate the inflation expectations in the long-run is a
question mark.
Given the low natural rate, the room for higher interest rate in the future is limited even if the
economy strengthens temporarily. More likely, the central bank should study what alternative
polices are available to them.