The Natural Rate of Interest and Monetary Policy

Jerome Powell, the Fed Chairman, stated a while ago that the central bank is far from a point where the interest rate is neutral, i.e. that monetary policy is neither expansionary nor restrictive of economic growth. The neutrality argument essentially dictates that the prevailing interest rate tends neither to raise nor lower prices.

The response of prices to the interest rate is naturally a direct outcome of economic growth itself. In essence, prices tend to increase when higher growth is registered, a demand-side increase, as elaborated here. As such, the interest rate level at which the economy would grow a steady, long-run level, with prices equally stable, is referred to as the natural rate of interest. Similar to the natural rate of unemployment, the natural rate of interest does not refer to a fixed metric but rather to something which changes over time, always in sync with the prevailing economic conditions of the period.

Unlike the natural rate of unemployment, the natural rate of interest is not publicly available. In addition, complex econometric models are usually employed to gauge where that rate is. Despite all of this, there exists a rather simple way to gauge whether monetary policy is neutral or not. Throughout long periods of time, the long-term growth rate of real GDP has been approximated to stand at about 2% per annum. As such, this would suggest that any GDP growth rate above 2% would signify that the current real interest rate (i.e. the inflation-adjusted rate) is below its neutral point and thus monetary policy is accommodative and the economy is growing faster than expected. In contrast, any growth rate below this would suggest that the real interest rate is restrictive.

Have a look at the graph at the top of this post then: as real GDP deviation from 2% (red line) fluctuated around the zero line there was no reason to change interest rates. This can be observed in the period following the 2011 rate hike, where until the end of 2014 the deviation never exceeded 1%. In contrast, in 2015 GDP began to be persistently above zero, and the Federal Reserve intervened by raising interest rates. Notice now how well the future path was projected by the Fed: by late 2016, it was forecast that the GDP deviation would have increased through time and thus the rate hikes began.

As can be easily observed from the graph, the six, almost consecutive, rate hikes did not hamper the growth prospects of the economy as it still persists with registering a straight line, with an upwards trend, confirming what Powell commented: the interest rate is yet to be neutral, as it had been in the 2011-2014 period. In contrast, the interest rate is not high enough to pull growth back to more or less 2% and hence this would justify additional rate hikes.

Nonetheless, remember that interest rate neutrality is not something stable: if the ongoing trade war persists and its impact on the US economy increases, the Fed could just pause the interest rate increases. Until then, the December rate hike appears more likely than ever.

Click here to access the HotForex Economic Calendar

Dr Nektarios Michail

Market Analyst


Disclaimer: This material is provided as a general marketing communication for information purposes only and does not constitute an independent investment research. Nothing in this communication contains, or should be considered as containing, an investment advice or an investment recommendation or a solicitation for the purpose of buying or selling of any financial instrument. All information provided is gathered from reputable sources and any information containing an indication of past performance is not a guarantee or reliable indicator of future performance. Users acknowledge that any investment in FX and CFDs products is characterized by a certain degree of uncertainty and that any investment of this nature involves a high level of risk for which the users are solely responsible and liable. We assume no liability for any loss arising from any investment made based on the information provided in this communication. This communication must not be reproduced or further distributed without our prior written permission.