By: Phil Kernen

Monetary officials recently make more frequent references to the natural interest rate, setting investor expectations for upcoming rate increases to curtail demand and lower inflation. The natural rate represents where they think overnight interest rates will be to get inflation down. But what is the natural interest rate, and why does it matter?

A natural interest rate neither adds fuel to an economy nor holds it back, like a perfectly balanced steering wheel directing the car straight down the highway, driving neither left nor right. A more economic definition is the real short-term interest rate expected to prevail when an economy is at full strength and with stable inflation. Sometimes formula-loving economists refer to it as r* or r-star. 

The problem with the natural interest rate is that no one can see it or deduce it in advance, so no one knows the natural level at any given point. A quote from John H. Williams, a professor of economics at Harvard University from 1921 to 1957, sums it up, “The natural rate is an abstraction; like faith, it is seen by its works. One can only say that if the bank policy succeeds in stabilizing prices, the bank rate must have been brought in line with the natural rate, but if it does not, it must not have been.” 

That doesn’t stop economists from trying. In a March speech, Federal Reserve Bank of Cleveland President Loretta Mester said the natural rate was 2.5%. Federal Reserve Bank of Chicago President Chuck Evans said the natural level was about 2.4%. Federal Reserve Bank of San Francisco President Mary Daly said that the natural level was around 2.5%.

The definition of the natural rate of interest varies. Some research defines it as the real (inflation-adjusted) short-term interest rate consistent with the economy operating at its full potential once transitory shocks to supply or demand have abated. In other words, the research view is long-term and looks through any temporary volatility. Further research focuses on short-term fluctuations in the natural interest rate and assumes the long run stays constant.

The Federal Reserve Bank of New York created models based on previous research that provides estimates of the natural rate of interest. The models show a generally declining natural rate from the mid-1980s through 2020. They suspended the models due to the extraordinary volatility related to the COVID-19 pandemic. The models also don’t go back far enough to calculate the natural interest rate throughout the 1970s as inflation rose higher and higher, making us less clear where it should be with inflation so high today.

How can policymakers assess something based upon a still undetermined definition? Given the uncertainty around the natural rate of interest, it is surprising that so many Federal Reserve leaders use it as the benchmark rate to which they are driving monetary policy. It argues instead to deemphasize the natural interest rate as a target and reduce the risk of bad policy decisions.

Economists agree that the natural interest rate can change over time due to structural shifts in supply and demand, both of which occurred recently due to the pandemic and massive fiscal expansion. In addition, research shows that increases in long-run projections of federal government budget deficits are related to increases in expected long-term real interest rates. The 2020 deficit tripled pre-COVID levels to $3.1 trillion, and 2021 was slightly less at $2.7 trillion.

Consider one other thing about the Federal Reserve’s ability to determine the natural interest rate. Finding ourselves at the natural interest rate means that demand and supply are in relative balance. If our economy supplied more goods and services than demanded, prices would fall to find a new balance. If we ordered more goods and services than our productive capacity would provide, prices should be rising, as we are now experiencing. As Congress passed repeated fiscal stimulus bills, no one from the Federal Reserve stood up to protest that demand would quickly overtake supply, demonstrating the massive challenges in assessing aggregate supply and demand in a pandemic. How much harder still then for economists to calculate the natural interest rate that brings those two back into balance.

The upshot is that inflation is at 8.5%, and current estimates of the natural rate of interest rates at 2.5%, which assumes inflation is the target, are too low. Policy actions cannot ease into a natural rate and expect an off-the-rails inflation number to self-correct by 6.0%. The hope that 2.5% may be the top of interest rates is a false peak in this cycle. The Federal Reserve is going to have to move rates higher.