The discussion of about bond markets revolves around what is the right rate of interest for the long-run if we return to normal policy. To have this discussion, investors need to identify terms like the natural rate of interest and the neutral rate of interest. These have often been used interchangeably but there are some differences. Looking at these concepts help to frame any discussion on bond values.

The natural rate of interest is the rate which will allow for borrowing and lending to clear markets. It is the rate described by Knut Wicksell that reflects real factors that effect the price of consuming today or delaying consumption. It is the rate of interest that balances savings with investment. The natural rate will change with demographics and productivity. It has been described as the rate that avoids booms and busts and places the economy on a sustainable growth path.

It has been associated with the Austrian school of thinking and is not easily measured. The natural rate is one that is unaffected or controlled by policy. Generally, this has been viewed as the rate that is consistent with long-term trend growth in the economy. If long-term trend growth is 2%, the natural rate should also be 2%. This is a real rate so if you add inflation, the natural rate at the Fed target of 2% should be 4%. However, there is significant disagreement on this level. Some economists have measured what they think is the natural rate and find it has been declining. This is a reason for the distinction with what may be called the neutral rate of interest.

The neutral rate of interest is a more dynamic measure of what could be called the equilibrium interest rate. The neural rate is the interest rate that will allow for sustainable growth at the long-term trend. In this case, the neutral rate is tied to the output gap. If there is a output gap with growth below trend, the neutral rate should be lower to reflect the fact that current growth has to be higher in order to match long-term trend. Similar to the natural rate, it will be effected by long-term growth, demographics, and productivity but seems to reflect the deviations from trend. Some suggest that the rate described by the Taylor Rule represents the neutral rate of interest.

The neutral rate of interest could equal the natural rate in equilibrium but if the economy is away from equilibrium, the neutral rate may be lower than the natural rate. Given it could be tied to the Taylor Rule, it can be measured.

So what should it be? I can live with a Taylor Rule measure as the neutral rate of interest and accept a difference between the natural and neutral rate. The purpose of having this discussion is that it can frame issues of whether current rates are over or under-valued. By a Taylor Rule measure, rates are too low although the neutral rate seems lower than the natural rate.

We are still in a rate world that is out of equilibrium and any adjustment to equilibrium will likely cause cause rates to rise.