Natural and Neutral Real Interest Rates: Past and Future

Monetary theory posits a critical real rate of interest below which the monetary policy setting is inflationary and above which it is deflationary. For roughly a decade after the Great Financial Crisis (GFC), many economists linked deflationary pressures to the difficulty central banks encountered in attaining sufficiently low policy interest rates after decades of global decline in real market rates. In contrast, some ascribe the recent global upsurge in inflation to central banks’ tardiness in raising real policy rates high enough to place a sharp brake on demand. This paper surveys the decline in real interest rates in advanced and emerging economies over the past several decades, linking that process to a range of global factors that have operated with different force in different periods. The paper argues that estimates of the long-run equilibrium real rate, which I call the natural rate (r̄), may not always furnish an accurate guide to the rate appropriate for short-term monetary policy, which I call the neutral rate (r ⃰). It suggests that monetary policymakers should consider not only equilibrium in the market for domestic goods, but also the current account balance, financial conditions (including gross capital flows), and imperfect policy credibility. According to market indicators, expected long-term real interest rates have now risen to around the levels that prevailed just before the GFC. However, some of the main underlying factors that pushed real interest rates down after the 1980s and 1990s (notably demographic shifts, lower productivity growth, corporate market power, and safe asset demand relative to supply) may remain relevant. The big open question is whether recent developments including geopolitical tensions, bigger government deficits, deglobalization, and possible productivity gains from generative AI will overpower other ongoing trends to produce a further durable rise in global real interest rates. If not, low equilibrium interest rates may well continue periodically to bedevil monetary policy and financial stability. But if so, fiscal crises become a bigger risk.