UNIQA Capital Markets Weekly

Central bankers have frequently been referring to the so-called ‘natural’ or ‘equilibrium’ real rate of interest.  In recent years, the concept – that originally dates back more than 100 years to Knut Wicksell’s work  – has had a revival in theory and policy discussions and a vivid body of economic literature has emerged around the topic. Nowadays, also banks and insurers started to make use of the estimates as a guidepost in shaping their long-term outlooks and planning decisions.

The natural rate of interest

In Wicksell’s spirit, the natural rate is defined as the interest rate that is compatible with a stable price level. An increase in the interest rate above its natural rate contracts economic activity, while a decline relative to the natural rate has the opposite effect. Critically, the natural rate relates to economic fundamentals such as productivity or changes in consumers’ preferences and demographics. These longer-run real factors affect saving and investment and, thereby, the rate of interest that equilibrates the market such that full employment can emerge. Therefore, the long-term trend in slowing productivity and the aging population have increasingly been seen in relation with the decline in the natural interest rate (or sometimes simply “r-star” among economics wonks).  Importantly, the logic also implies that it is out of reach of central banks’ toolkit and cannot be directly influenced by monetary policy! However, as the natural rate presumably changes very slowly, it gives economists and policy makers a powerful tool to predict long-term trends in interest rates.
The problem with the natural rate is that it is not directly observable; it is a latent variable that has to be retrieved from other observable data making use of complex econometric models. San Francisco Fed President John Williams (with various co-authors) has probably developed the most prominent and most frequently cited model for estimating the natural rate of interest (“Laubach-Williams” model). 
Based on the existing literature, all we know about r-star is that it is very low in historical perspective and in its absolute level and may even have been negative for some time.

New evidence

In a new paper, authors from the Federal Reserve Bank of San Francisco added a novel estimate to the literature (Figure 1).  In contrast to existing models, the estimates use data from the financial markets (i. e. it is “finance-based”), the prices of U. S. treasury inflation-protected securities (TIPS). These instruments pay coupons and principal adjusted for changes in the consumer price index (CPI) and compensate investors for the erosion of purchasing power due to inflation. It is assumed that the longer-term expectations embedded in TIPS prices reflect financial market participants’ views about the state of the economy including the equilibrium interest rate. Figure 1 (from the article) contrasts the estimate of the natural rate based on the TIPS data (going back to the 1990s when the issuance program was launched) with the previous approach that was based on macroeconomic variables (Laubach-Williams).

Most importantly, both methodologies imply that the equilibrium rate is currently near its historical low, although the finance- and macro-based estimates rely on different assumptions about the structure of the economy and different data sources. Finally, the authors note that “the model dynamics of fluctuations in the equilibrium rate are estimated to be very persistent”. The natural rate is more likely than not to remain near its current low at least the next several years.

Eurozone: Sentiment remained robust in June

In June, the purchase manager indexes (PMIs) – among the most prominent leading economic indicators for the Euro Area – retreated slightly from the ultra-high levels they had reach over the last couple of months (Figure 2). Overall, the results were still robust and indicate the continuation of a solid cyclical business environment.
The headline composite PMI decreased gradually to 55.7 from 56.8 in the previous month. The move was due to a lower reading for the services sector (54.7 after 56.3), while the manufacturing PMI rose from 57.0 to 57.3. On the country level, the German manufacturing PMI remained quite stable at a level suggesting expansion in the sector (59.3 after 59.6), while the services component fell compared to the May reading (from 55.4 to 53.7). In France, the manufacturing PMI index rose (from 53.8 to 55) and the services index decreased (55.3 after 57.2).