- Central banks currently find themselves in a tight spot. Soaring inflation rates must be kept in check, but rate hikes risk choking off economic growth
- To succeed, they will need to raise interest rates to the elusive ‘natural’ rate
Central bankers are in an unenviable position: if they raise interest rates too little, they risk a deleterious inflationary spiral. But if they raise them too far, they risk derailing economic growth and tipping their economies into recession. To be successful, rates need to settle on a sweet spot which leaves the economy running neither too hot nor too cold. And this Goldilocks of monetary policy is known as the ‘natural’ rate of interest.
The ‘natural’ rate is the short-term interest rate that prevails when the economy is in a stable equilibrium. It is sometimes also called the ‘neutral’ interest rate, nicely capturing its unobtrusiveness: it is the theoretical level where interest rates are not so high that they pressure the economy to slowdown, nor so low that they are driving it to expand.
Since the 1980s, natural rates in advanced economies have followed a protracted downward trend. Since the turmoil financial crisis in particular, risk-averse savers have needed less incentive to squirrel money away, and this ready supply of savings has put downward pressure on interest rates. As my chart shows, the US natural rate of interest (long-run projections for Fed Fund rates are often used as a proxy) has fallen almost 2 percentage points over the past 10 years.
And these low natural rates have been a headache for policymakers – with rates so close to zero, there is very little room to cut them further when the economy needs reviving. With reduced scope for rate cuts, central banks have been forced to use more creative monetary policy tools: think the widespread use of quantitative easing since the financial crisis and the more recent use of negative interest rates in the EU.
For now, good old-fashioned rate changes are back on the menu. The ECB intends to increase interest rates for the first time in 11 years this July, with further increases planned for September. The Fed’s rate-setting committee has indicated that rates above 3.5 per cent are likely by 2023. Following its fifth consecutive rate rise, the Bank of England last week also pledged to move ‘forcefully’ to tackle to any persistent inflationary pressures. But increase rates too far, and a recession could follow. The challenge for central banks will be to end their cycle of rate rises with a ‘terminal rate’ not too far from the economy’s natural rate of interest.
According to research from Capital Economics’ group chief economist, Neil Shearing, inflation in the eurozone is likely to be tamed by bringing interest rates back to their natural rate. It is worth noting that the structure of the eurozone may reduce the chance of the ECB ‘overshooting’ its natural rate, too. The sizeable number of voters on the ECB's governing council, representing all the eurozone's different member states, can make decision-making more difficult.
By contrast, Shearing argues that the Fed and the Bank of England may need to push beyond their economy's natural rates to bring inflation to heel. This means we could see interest rates peaking at 3.75-4 per cent in the US, and at 3 per cent in the UK.
But this sort of fine-tuning is easier said than done. As is often the case in economics, a precise-sounding term belies a world of uncertainty. The natural rate of interest is not something a central bank can control: it is determined by the underlying characteristics of the economy, and economists can only do their best to estimate it. It is also a long-term concept, referring to the rate of interest an economy ‘settles into’ after any booms and busts have played out. This is a problem when global markets are so unsettled. In a world of energy price spikes, supply chain constraints and the continuing spread of the Covid-19 Omicron variant, spare a thought for central bankers – the natural rate is an even harder target to hit in tumultuous times.
