The natural or neutral rate of interest

The natural rate of interest, or as recently expressed by PIMCO, the neutral rate of interest is a hot topic for both economists and investors. If the natural rate of interest is lower than current levels and negative, do not hold bonds. Inflation will have to rise to push those real rates down. If the natural rate of interests should stay low, then there is an argument to continue to hold bonds in a portfolio. If the natural rate is expected to rise or be higher, investors best find someplace else to hold their money.

We can go back over 100 years for discussion of what is the natural rate of interest.  Some of the early work of Knut Wicksell describes it as the neutral rate where commodity prices are not biased higher or lower and is determined by the balance of supply and demand for real capital goods. It will be related to aggregate demand in the economy which can be measured by the output gap. The output gap can be viewed as the sum of future real interest rate gaps which is based on time preferences, growth of technology, and the conditional variance of technology. In more sophisticated models, the natural rate is related to risk shocks and wage rigidities. Certainly, a risk shock has pushed down the current natural rate.

The latest research suggests that the natural rate will be volatile and pro-cyclical. What has been unusual has been the persistent negative value for the natural rate in the post Great Recession period. This is, however, consistent with the large output gap. This natural rate can serve as a useful benchmark for the Fed, If the natural rate is negative then the Fed has to follow policies that will drive rate rates lower in the face of zero bound if the output gap is to be closed.

This is easy to put into words but the measurement of the natural rate or the output gap is very difficult and up for much interpretation.