The Natural Rate of Interest

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.

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.