What anchors for the natural rate of interest?

BIS Working Papers  |  No 777  | 
26 March 2019



We examine the prevailing view that only saving and investment drivers influence the long-term evolution of real, or inflation-adjusted, interest rates. That view also relies on the notion of a natural, or equilibrium, real interest rate that is independent of monetary policy. By contrast, we argue that monetary factors matter.


We test the role of saving and investment drivers based on a large set of advanced economies since the 1870s. We also examine the popular hypothesis that a shortage of risk-free, or "safe" assets, has led to an excess of saving over investment and driven down real interest rates. We compare the relevance of these factors with that of monetary ones. To shed light on the findings, we propose a novel model where monetary factors play a key role by interacting with the financial cycle.


Our analysis finds prevailing explanations of low real interest rates wanting. By contrast, it indicates that shifts in monetary policy regimes play a greater role. In our stylised model, monetary policy affects an economy's vulnerability to a financial bust by influencing the boom. It thus helps determine the long-run path of output and real interest rates. Our findings raise questions about the usefulness of the natural interest rate as a policy guide. They also suggest that monetary policy cannot ignore financial booms and busts.



The paper takes a critical look at the conceptual and empirical underpinnings of prevailing explanations for low real (inflation-adjusted) interest rates over long horizons and finds them incomplete. The role of monetary policy, and its interaction with the financial cycle in particular, deserve greater attention. By linking booms and busts, the financial cycle generates important path dependencies that give rise to intertemporal policy trade-offs. Policy today constrains policy tomorrow. Far from being neutral, the policy regime can exert a persistent influence on the economy's evolution, including on the real interest rate. This raises serious conceptual and practical questions about the use of the natural interest rate as a monetary policy guidepost. In developing the analysis, the paper also provides a specific critique of the safe asset shortage hypothesis - a hypothesis that has gained considerable popularity in recent years.

JEL classification: E32, E40, E44, E50, E52

Keywords: real interest rate, natural interest rate, saving, investment, inflation, monetary policy, safe asset shortage hypothesis