The Natural Rate of Interest
The natural rate (r-star) is the real interest rate at which the economy runs at full employment with stable inflation — it is a benchmark central banks aim for, not a number anyone directly observes.
The natural rate of interest, often written r-star (r*), is the real (inflation-adjusted) interest rate that would keep the economy neither overheating nor stalling — output at its potential, inflation steady. It is the invisible target a central bank is aiming for when it sets policy rates, even though nobody can read r* off a screen the way they read the fed funds rate.
r-star is the interest rate at which monetary policy is neither pressing the accelerator nor the brake. A policy rate above r-star (after adjusting for inflation) is contractionary; below it, expansionary — and r-star itself has to be estimated, not observed.
Why it matters
Central banks describe policy as "accommodative" or "restrictive" relative to r-star, not relative to zero. A 4% policy rate is loose if r-star is 5%, and tight if r-star is 2%. Because r-star drifts — with demographics, productivity growth, and global savings gluts — a rate that was neutral a decade ago can become too high or too low today without the central bank changing anything.
Worked example
Suppose the fed funds rate is 5.25% and expected inflation is 2.5%, giving a real policy rate of about 2.75%. If economists estimate r-star at 0.5%, real rates are running roughly 2.25 percentage points above neutral — policy is meaningfully restrictive, consistent with cooling demand. If r-star had instead risen to 2%, the same 5.25% nominal rate would be barely restrictive at all, which is exactly the debate that played out in markets after 2020 as estimates of r-star were revised upward.
Estimates of r-star (from models like Laubach-Williams) carry wide confidence bands and get revised often — treating a single point estimate as fact is a common mistake, when in reality it is one noisy input among several a central bank weighs.
Related concepts
Practice in interviews
Further reading
- Williams, 'Measuring the Natural Rate of Interest' (FRBSF)