The neutral real interest rate.

• Author: Bernhardsen, Tom

The concept "neutral real interest rate" is generally associated with the real interest rate level, which implies that monetary policy is neither expansionary nor contractionary. We define the neutral real interest rate as the real interest rate level which in the medium term is consistent with a closed output gap. We consider in more detail how the neutral real interest rate in a small, open economy is influenced by global conditions. The neutral real interest rate cannot be observed, and estimates are uncertain. Different methods for estimating the neutral real interest rate are presented in this article. An overall assessment implies that it will normally lie in the range of about 2 1/2-3 1/2 per cent in Norway. In recent years, with low real interest rates globally, we cannot exclude the possibility that the neutral real interest rate in Norway may be even lower. The neutral real interest rate has probably been falling since the 1980s and early 1990s, partly as a result of lower inflation risk premia.

1 Introduction

The interest rate is the most important monetary policy instrument. It may be set so that monetary policy is expansionary, contractionary or neutral. The concept "neutral real interest rate" is generally associated with the real interest rate level, which implies that monetary policy is neither expansionary nor contractionary. If the central bank aims to stimulate economic activity, the interest rate must be set so that the real interest rate is lower than the neutral rate. If the central bank aims to dampen activity, the interest rate must be set so that the real interest rate is higher than the neutral rate. (2)

The concept "neutral real interest rate" stems from the Swedish economist Knut Wicksell (3), who maintained about a hundred years ago that the general price level would rise or fall indefinitely as long as the real interest rate deviated from the neutral interest rate (4). The neutral real interest rate cannot be observed, however, and estimates are uncertain. Blinder (1998) states that: "... the neutral real rate of interest is difficult to estimate and impossible to know with precision. It is therefore most usefully thought of as a concept rather than as a number, as a way of thinking about monetary policy rather than as the basis for a mechanical rule ..."

The neutral real interest rate is an important concept, nonetheless, for assessing the monetary policy stance. Central banks must have a perception of how expansionary or contractionary monetary policy is. This requires an assessment of the level of the neutral real interest rate.

There are a number of real interest rate concepts. It is particularly important to distinguish between the long-term equilibrium real interest rate, the neutral real interest rate and the actual real interest rate. The long-term equilibrium real interest rate is determined by economic fundamentals such as growth potential and private saving behaviour. The neutral real interest rate is in addition determined by various disturbances that affect the supply and demand side of the economy in the medium term. The neutral real interest rate may deviate from the long-term equilibrium real interest rate, but will move around and towards it over time. The actual real interest rate is largely determined by the level of the central bank's official policy rate, and therefore depends on the objectives of monetary policy and the disturbances to which the economy is exposed. The actual real interest rate may therefore differ from the neutral real interest rate for shorter or longer periods of time. (5)

The long-term equilibrium real interest rate is discussed in the next section. The neutral real interest rate and the relationship between the different real interest rate concepts are then considered in more detail. First, the concepts for a closed economy are discussed and in Section 4 the neutral real interest rate in a small, open economy is considered in more detail. Free movement of capital across countries implies that interest rates --including the neutral real interest rate--are influenced by global conditions. Section 5 investigates how the neutral real interest rate can be estimated empirically, and what may be regarded as reasonable estimates of the neutral real interest rate, globally and in Norway. Section 6 provides a summary.

2 The long-term equilibrium real interest rate

Economic growth theory may shed light on what determines the real interest rate in the long term. In the Ramsey model, the long-term real interest rate is determined by economic fundamentals such as productivity and population growth and household saving preferences. Prices are assumed to be flexible, and input factors to be mobile. All markets are therefore in equilibrium. Under a number of simplified assumptions it can be shown that:

(1) [r.sup.**] = g + n + [rho]

The long-term equilibrium real interest rate ([r.sup.**]) is determined by growth potential, i.e. the sum of productivity growth (g) and population growth (n) in addition to the household rate of time preference ([rho]). The more weight households place on consumption today relative to future consumption, the higher the time preference rate is. (6)

According to the Ramsey model, the real interest rate and potential growth move more or less in tandem. It is assumed that households prefer to smooth consumption over time. Higher potential growth and hence higher expected income therefore increase the propensity to consume and reduce the propensity to save. This implies a higher real interest rate. The more households prefer to consume today relative to the future, i.e. the more impatient they are, the lower the propensity to save and the higher the real interest rate.

Higher potential growth can also lead to a higher long-term equilibrium real interest rate via higher demand for investment. When productivity growth increases, for example, this will increase the marginal return on capital. A marginal return that is higher than the real interest rate increases the propensity to invest. Investment demand and the equilibrium real interest rate will accordingly rise. (7) This is consistent with Wicksell (1907) who maintained that: "... the upward movement of prices, whether great or small in the first instance, can never cease so long as the rate of interest is kept lower than its normal rate, i.e. the rate consistent with the then existing marginal productivity of real capital."

The relationship between investment and saving is illustrated in Chart 1. Investment demand ([I.sup.0]) is negatively dependent on the real interest rate, because a lower real interest rate makes fixed investment more profitable. The saving curve ([S.sup.0]) is rising because households are assumed to reduce current consumption relative to future consumption when the real interest rate increases. It is important to distinguish between preferred quantities ex ante and actual quantities ex post. Preferred saving ex ante may be different from preferred investment. It is then up to the real interest rate to achieve a balance so that these are equal ex post (point A on the chart). Globally--or in a closed economy--saving is always equal to investment ex post.

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Changes in potential growth and the household rate of time preference lead to permanent changes in saving and investment behaviour and hence to changes in the long-term equilibrium real interest rate. A higher investment preference shifts the demand curve outwards in Chart 1 (from [I.sup.0] to [I.sup.1]). The new and higher real interest rate level generates more saving, so that the increase in investment demand is covered. A new adjustment takes place at point B. One way of looking at this is that when investment demand increases, the economy needs a higher real interest rate in order not to overheat, and it can take the higher real interest rate without dampening the activity level. A higher saving preference shifts the saving supply outwards (from [S.sup.0] til [S.sup.1]). A lower real interest rate leads to higher investment, which accordingly absorbs the increase in the saving supply. A new adjustment takes place at point C. When the saving supply increases, the economy can take a lower real interest rate without overheating, and it needs a lower real interest rate to prevent a dampening of the activity level.

The Ramsey model is stylised and most useful as a starting point for assessing long-term developments in the real interest rate. The model indicates a long-term relationship between potential growth and the real interest rate.

3 A closer look at the neutral real interest rate

Definition

The concept "neutral real interest rate" is generally associated with the real interest rate level which implies that monetary policy is neither expansionary nor contractionary. There is no definitive definition of the neutral real interest rate, and there are a number of approaches to it in the literature.

Yellen (2005), president of the San Francisco Federal Reserve, states: "Conceptually, policy can be deemed "neutral" when the federal funds rate reaches a level consistent with full employment of labor and capital resources over the medium run."

We accordingly define the neutral real interest rate as the real interest rate level, which in the medium term is consistent with a closed output gap. The output gap is defined as the difference between actual and potential output, which is the output level that is consistent with stable inflation over time. Chart 2 illustrates a hypothetical path for the real interest rate and the output gap. The central bank sets the interest rate such that the monetary policy objectives are expected to be achieved. In the medium term, the output gap is expected to stabilise at around zero. (8)

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The neutral real interest rate can change over time. Yellen describes this as follows: "The value of [the neutral rate] depends on the...