Natural Rate of Interest

The Natural Rate of Interest, also known as r-star (r*), is the theoretical real interest rate that keeps the economy at full employment with stable inflation over the medium term. This unobservable rate serves as a crucial benchmark for monetary policy – when actual rates are below r*, policy is stimulative; when above, it’s restrictive. Central banks estimate r* has declined significantly since the 1980s, from around 3-4% to near 0% in many developed economies. This decline reflects factors including aging populations, slower productivity growth, and increased global savings. For instance, the Federal Reserve estimates the US r* at approximately 0.5% as of 2024, meaning a 2.5% federal funds rate (0.5% real + 2% inflation target) represents neutral policy. The concept helps explain why interest rates remained low for extended periods post-2008 without spurring inflation – the natural rate itself had fallen. Investors use r* estimates to assess whether monetary policy is truly accommodative or restrictive beyond just looking at nominal rate levels.