Natural Rate of Interest
The real interest rate consistent with an economy at full employment and stable inflation, also known as r-star or the neutral rate.
What is Natural Rate of Interest?
The natural rate of interest (r* or r-star) is the hypothetical real short-term interest rate at which monetary policy is neither stimulative nor restrictive — the rate that keeps output at its full potential and inflation stable at the central bank's target. First described by Swedish economist Knut Wicksell in 1898, r-star cannot be directly observed and must be estimated using macroeconomic models such as the Holston-Laubach-Williams framework. When the actual real interest rate is below r*, monetary policy is accommodative and tends to stimulate growth; when it is above r*, policy is contractionary. A falling r-star, as observed since the 1980s in most advanced economies, means central banks have less room to cut rates before hitting the effective lower bound.
Example
The New York Fed's Holston-Laubach-Williams model estimated the U.S. r-star at approximately 1.1% in late 2024, well below its pre-2008 level of around 3.0%. This decline implies the Fed must keep its policy rate lower than in past cycles to achieve the same level of monetary accommodation, reducing its future capacity to cut rates in a downturn.
Source: Federal Reserve Bank of New York — Measuring the Natural Rate of Interest