What do strong labour markets tell us about monetary �ghtening in the euro area, US and UK?
Zsolt Darvas and Catarina Mar�ns
7 November 2023

Abstract
Despite signiﬁcant interest rate hikes by the Bank of England, the European Central Bank, and theFederal Reserve since the post-pandemic inﬂa�on surge, and other global shocks like the war in
Ukraine and China’s slowdown, the euro area, UK and US economies proved to be surprisingly
resilient. Recessions have been avoided, and labour markets are at historical highs. In this paper, we
document the similari�es and diﬀerences between the current monetary �ghtening episode withearlier episodes and analyse the developments of actual and equilibrium interest rates. We argue
that a possible explana�on for the anomaly of resilient economies despite monetary �ghtening andglobal shocks can be the extent of monetary �ghtening: moving from a highly accommoda�vemonetary policy stance to a broadly neutral (but not contrac�onary) monetary policy stance. Ourﬁndings imply that (1) unless central banks will signiﬁcantly �ghten further, monetary policy isunlikely to exert a signiﬁcantly nega�ve eﬀect on the economy, (2) the reduc�on of core inﬂa�on
might prove to be challenging, while headline inﬂa�on falls along with a decline in energy prices, and(3) high nominal interest rates might persist for long.

This paper was prepared for the Nomura Founda�on’s Macro Economy Research Conference 2023
on ‘Monetary Policy and its Impact during Inﬂa�on’, Tokyo, 19 October 2023. The authors thank the
Nomura Founda�ons for support, conference par�cipants for useful comments and sugges�ons, andConor McCaﬀrey and Lennard Welslau for their help with Bloomberg data.

Zsolt Darvas is Senior Fellow at Bruegel and Senior Research Fellow at Corvinus University ofBudapest.
Catarina Mar�ns is a PhD student at the Stockholm School of Economics and was a Bruegel Research
Analyst when most of this research was prepared.

11. Introduc�onInﬂa�on increased to close to 10% in advanced countries in 2022, far exceeding the 2% inﬂa�ontarget. Following an era which was labelled as “low for long”, referring to various explanatory factorsthat can keep real interest rates and inﬂa�on low, the huge inﬂa�on shock came as a surprise.
Among advanced countries, inﬂa�on pressures emerged ﬁrst in the United States in the spring of
2021. This ini�al inﬂa�on surge was related to the recovery of the US economy from the COVID-19
pandemic recession, the Federal Reserve’s monetary s�mulus, and the massive ﬁscal s�mulus thatini�ally President Trump, and then President Biden, implemented. At the same �me, supply
disrup�ons due to the pandemic resulted in shortages of key inputs, while US consump�on shi�edfrom services to goods, but goods demand was not matched by the supply. Global commodity prices
started to surge in early 2021, up from the lows observed during the 2020 pandemic recession. The
increase in energy prices accelerated with Russia’s threat to invade Ukraine in the second half of2021, and further escalated a�er the invasion actually happened in February 2022. The later energy
price increase proved to be temporary since, by the end of 2022, energy prices fell below values
observed before the invasion.
Despite rising inﬂa�on in 2021, all forecasters foresaw only a small and temporary rise in inﬂa�on.
For example, in November 2021, the European Commission forecast suggested 3.3% inﬂa�on in the
United States, 3.2% inﬂa�on in the United Kingdom and 2.2% inﬂa�on in the euro area in 2022,
followed by lower inﬂa�on in 2023 – 2.2% in the US and UK, and 1.4% in the euro area. Other
mul�lateral ins�tu�ons like the IMF and OECD, central banks, and private professional forecasters did
no beter in predic�ng the 2022 huge inﬂa�on surge.
Perhaps related to this forecas�ng failure, major central banks kept highly expansionary monetary
policy stances un�l inﬂa�on had already increased to high levels. Interest rate hikes started belatedly.
The Bank of England opened the line of interest rate hikes in December 2021, when inﬂa�on was
already 5.4%. The Federal Reserve started interest rate hikes in March 2022, when inﬂa�on was 5.8%
in terms of the price deﬂator of private consump�on expenditures (PCE) and 7.0% in terms of theconsumer price index (CPI) 1. The ﬁrst rate increase of the European Central Bank was implemented
in July 2022, when inﬂa�on had reached 8.9%. Net asset purchases were terminated a month earlier
than the ﬁrst interest rate hike in the case of the Bank of England, and in the same month as the ﬁrst
interest rate hike in the cases of the Federal Reserve and ECB. The reduc�on of central bank asset
holding started three months later in the cases of the Bank of England and the Federal Reserve.
Beyond the forecas�ng failure, the reasons for the 2021 complacency about inﬂa�on could havebeen fuelled by three factors. The ﬁrst is the diﬃculty in leaving behind the narra�ve of “low forlong”, when central banks achieved limited success in increasing inﬂa�on from below-target levels.
Since the Federal Reserve switched to average inﬂa�on targe�ng in August 2020 (implying that
below-target inﬂa�on should be compensated by above-target inﬂa�on) and the ECB replaced its
ambiguous “close to but below 2% over the medium-term” objec�ve with a symmetric 2% inﬂa�ontarget in July 2021, some inﬂa�on above 2% inﬂa�on must have been welcomed by central bankers 2.
Secondly, monetary policy can best address excess demand surges, but there were important supplyside botlenecks which contributed to inﬂa�on. Due to the pandemic, global trade ﬂows were
The Federal Reserve inﬂa�on target indicator is the price deﬂator of private consump�on expenditures (PCE),
not the CPI. The US CPI data is more comparable to euro area HICP and UK CPI data than the PCE data.
2
See Darvas and Mar�ns (2021) for an evalua�on of the ECB’s new inﬂa�on target.
1

2

impaired, shipping costs skyrocketed, and there were shortages of various materials. In Europe,
Russia started to cut back its gas supply to the EU several months before the full-scale invasion
started. The drought in the summer of 2021 compromised hydropower genera�on and factories
needing large volumes of cooling water, while corrosion problems resulted in the temporary
shutdown of some French nuclear power plants. All these factors resulted in an increased use ofnatural gas in electricity genera�on in Europe, at a �me when less Russian gas arrived in thecon�nent. The uncertainty about the demand-side and supply-side drivers of inﬂa�on might haveurged central bankers to be cau�ous. Thirdly, long-term inﬂa�on expecta�ons (measured by marketbased indicators and the views of professional forecasters) seemed to remain anchored, giving
comfort to central bankers that a somewhat higher temporary inﬂa�on might not lead to persistently
high inﬂa�on.
A further important reason for the delayed monetary �ghtening by the ECB is related to its ﬂawed
forward guidance. One of the self-set condi�ons for an interest rate increase was the termina�on ofasset purchase programme (APP) net purchases, yet the December 2021 ECB Governing Council
mee�ng increased monthly APP net purchase volumes for the second and third quarters of 2022 andspeciﬁed a return to the monthly pace of EUR 20 billion “from October 2022 onwards […] for as longas necessary to reinforce the accommodative impact of our policy rates”. This implied that the APP
would con�nue a�er October 2022, and thus interest rates could be increased even later. Eventually,
the ECB could not keep these self-imposed deadlines and started to li� its interest rates in July 2022 3.
From the start of the current monetary policy �ghtening cycle up to the �me of wri�ng, October
2023, the Federal Reserve increased its main interest rate by 5.25 percentage points, the Bank ofEngland by 5.15 percentage points, and the ECB by 4.5 percentage points (Figure 1). These arerela�vely large increases in nominal interest rates from a historical perspec�ve. Yet monetary policy
was highly accommoda�ve before the rate increases started, and the current �ghtening cycle has
two unique, poten�ally interrelated, features that diﬀer from earlier �ghtening cycles. First, peakinterest rates have not even neared peak inﬂa�on rates. Second, labour markets remained strong,
reﬂected in the historically low unemployment rates, in which no no�ceable deteriora�on can beobserved by the �me of wri�ng (Figure 1). Other labour market indicators, such as the growth rate ofjobs, and vacancy rates, suggest similarly strong labour markets. In this paper, we examine these twosalient features and draw implica�ons for the course of monetary policy.

3

See Darvas and Mar�ns (2022) for an analysis of the ECB’s forward guidance.

3

Figure 1: Central bank interest rate, inflation and unemployment during the recent monetary
tightening episode of the Euro area, the United States and the United Kingdom, January 2020September 2023
Euro area

United Kingdom

All items inflation
Core inflation
Unemployment rate
Deposit facility rate4
2

All items inflation
Core inflation
Unemployment rate
Bank rateJul-2023

Jan-2023

Jul-2022

Jul-2021

Jan-2022

Jan-2021

Jul-2020

Jan-2020

Jul-2023

0Jul-2022-2

6

Jan-2023

0

8

Jan-20220

10Jul-20212

12Jul-20202

14Jan-20214

16

Jan-2020

4

Jul-2023

6

Jul-2022

6

Jan-2023

8

Jan-20228

Jul-202110

Jan-202110

Jul-2020

12

Jan-2020

12

United States

All items inflation
Core inflation
Unemployment rate
Federal funds rate

Sources: OECD main economic indicators for All items inﬂation, Core inﬂation and Unemployment rate (the September 2023
values for the euro-area inﬂation are from Eurostat and for the US from the Bureau of Labor Statistics); national central
bank websites for interest rates.

2. Monetary �ghtening: then and now
The 2022 inﬂa�on in advanced countries was similar to inﬂa�on observed in the 1970s and 1980s.
There was a less pronounced inﬂa�on surge in the 1950s. We compare the developments of main
macroeconomic indicators before and a�er the peak inﬂa�on during these four inﬂa�onary episodes,
for the United States, United Kingdom, Germany and France (Figure 2). From the euro area, wereport values for Germany and France, and not for the euro area as a whole, because the euro did
not exist before 1999, and na�onal developments were diverse then. The deﬁni�on andinterpreta�on of the variables, which are ploted in Figure 2, are presented in Box 1.

-------------------------------------------------------------------------------------------------------------------------------------Box 1: Deﬁni�on of macroeconomic variables ploted in Figure 2
CPI_Headline: Consumer Price Index – All items Total, growth rate compared to the same period theprevious year, percent; source: OECD.
CPI_Core: Consumer Price Index – All items non-food non-energy, growth rate compared to the same
period the previous year, percent; source: OECD.
CBrate: central bank main policy rate; source: collected from the websites of the respec�ve central
banks.

4

GDP_ConstantPrices: GDP by expenditure – Total GDP, at constant prices (index 2015=100), growthrate same period of the previous year, seasonally adjusted; source: OECD na�onal accounts
Ac�vity_rate: Ac�ve popula�on (employed plus unemployed) divided by the working-age popula�on,
All persons aged 15 and over, seasonally adjusted, percent; source: OECD.
Employment_rateSA: ra�o of people employed to working-age popula�on; working-age popula�onrefers to people aged 15 to 64; percent, seasonally adjusted; source: OECD.
HUnemployment_rateSA: harmonised unemployment rate; the unemployed are people of working
age who are without work, are available for work, and have taken speciﬁc steps to ﬁnd work; thera�o of the number of unemployed people as a percentage of the labour force, which is deﬁned as
the total number of unemployed people plus those in employment; all persons aged 15 and over;percent, seasonally adjusted; source: OECD.
Inac�vity_rateSA: Those are considered inac�ve in the working-age popula�on (people neither in
employment or deﬁned as unemployed) divided by the working-age popula�on; all persons aged 15
and over, percent, seasonally adjusted; source: OECD.
Unﬁlled_vacanciesSA: Unﬁlled vacancies divided by the labour force (number of unemployed people
plus those employed), ra�o, percentage, seasonally adjusted; source: OECD.
All_pctGDP: Credit to the private non-ﬁnancial sector from all sectors at market value, percent of
GDP - adjusted for breaks; source: BIS.
Banks_pctGDP: Credit to private non-ﬁnancial sector from banks, total at market value, percent of
GDP - adjusted for breaks; source: BIS.
--------------------------------------------------------------------------------------------------------------------------------------In the United States, both headline and core inﬂa�on in 2022 remained somewhat below theinﬂa�on peaks in 1970s and 1980s, but were considerably higher than in the 1950s. A�er theinﬂa�on peak in 2022, headline inﬂa�on was falling at more or less the same pace as in the 1970s
and 1980s, but core inﬂa�on remained much more persistent now. The nominal interest rate (theFederal Funds rate) remains much lower now than in the 1970s and 1980s, when rates were above
10%. The US economy entered a recession in the 1970s and 1980s, but not now. In line with beter
growth performance, the labour market performance is also much beter now than in the 1970s and1980s. The employment rate is higher now than then, and this rate went up further a�er theinﬂa�on peak in 2022, while it fell signiﬁcantly in the 1970s and 1980s. On the other side of thisdevelopment, the unemployment rate is at historical lows in the US now, and the rate has remained
stable a�er inﬂa�on peaked in 2022. In contrast, the unemployment rate went up signiﬁcantly in the
1970s and 1980s. The reason for the low unemployment is not a reduc�on in ac�vity, in fact, theinac�vity rate has fallen somewhat in 2022-2023. Data on unﬁlled vacancies is unfortunately notavailable for the earlier monetary �ghtening episodes, so a comparison cannot be made. In 20222023, vacancies declined somewhat, but were not reduced to zero. Total credit has been falling in
2022-2023, but from a much higher level (note that total credit for episode 4 is ploted on the rightaxis on the last but one panel). Bank credit changed a litle and, in fact, started to recover marginally(again, bank credit for episode 4 is ploted on the right axis of the last panel).
Similar tendencies characterize the United Kingdom: lower central bank rate now than in the 1970s
and 1980s, core inﬂa�on remains steady now, GDP has not contracted (at least so far), the5unemployment rate remains low, unﬁlled vacancies remain high, while both total credit and bankcredit have been falling, but from higher ini�al levels than in the 1970s and 1980s.
German developments are also similar, with two notable diﬀerences. First, the level of inﬂa�on was
at record levels in 2022, above the inﬂa�on peaks in the 1980s, 1970s and 1950s. Second, GDP
growth fell below zero. Nevertheless, the unemployment rate has not increased this �me, unlike inprevious episodes, and unﬁlled vacancies are much higher now than before. Similarly to the US andUK, credit to the non-ﬁnancial private sector has been falling this �me, but from much higher levels
than at earlier inﬂa�on episodes.
And ﬁnally for France, the level of inﬂa�on is lower now than in previous episodes, possibly due toFrench domes�c energy regula�on, which resulted in much lower energy price increases in 2022
than on average in the euro area. France is the only country in our sample for which the inﬂa�on
peak in the 1950s was the highest. While GDP growth fell, it did not turn nega�ve. The
unemployment rate has been decreasing; unfortunately, data gaps do not allow comparison withearlier episodes.

Figure 2: Comparing current and earlier monetary tightening episodes
United States
All items CPI
15

12

12

9

9

6

6

3

3

0

-24-21-18-15-12 -9 -6 -3 0 3 6 9 12 15 18 21 24

0

20
15
10
5
0

-24-21-18-15-12 -9 -6 -3 0 3 6 9 12 15 18 21 24

Months before/after inflation peak
1957m41974m12

1980m3Central bank rate

Core CPI

152022m61957m4

Unemployment rate

1974m12

1980m3Months before/after inflation peak

59

38

58

37

57
3

56

36

55
-24-21-18-15-12 -9 -6 -3 0 3 6 9 12 15 18 21 2454

35-24-21-18-15-12 -9 -6 -3 0 3 6 9 12 15 18 21 24

Months before/after inflation peak
1974m12

1980m32022m61957m4GDP constant prices

1974m12

1980m3Months before/after inflation peak

170

10

110

160

100

150

90

140

80

130

70

120

0
-5

60
-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8

1974Q4

1980Q1-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8110

Quarters before/after inflation peak

Quarters before/after inflation peak2022Q2

1957Q2

1974Q4

1980Q1

61974m12

1980m32022m6

Credit from banks

Credit from all sectors
120

1957Q21957m42022m615-10-24-21-18-15-12 -9 -6 -3 0 3 6 9 12 15 18 21 24

Months before/after inflation peak

52022m639

60

61980m3Inactivity rate61
91974m1240

62

1957m41957m42022m6

Employment rate

120-24-21-18-15-12 -9 -6 -3 0 3 6 9 12 15 18 21 24

Months before/after inflation peak2022Q2 (RHS)

60

40

55

35

50

30

45

25

40

-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8

20Quarters before/after inflation peak
1974Q4

1980Q12022Q2

1957Q2 (RHS)Unfilled vacancies (% labour force)
10
8
6
4
2
0

-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8Quarters before/after inflation peak
1957Q2

1974Q4

1980Q12022Q2

United Kingdom
All items CPI

Central bank rate

Core CPI

30

30

20

25

25

16

20

20

15

15

10

10

5

5

0

0
-24-21-18-15-12 -9 -6 -3 0 3 6 9 12 15 18 21 24
Months before/after inflation peak
1956m41975m81980m512
8
4-24-21-18-15-12 -9 -6 -3 0 3 6 9 12 15 18 21 24
1956m42022m101975m81980m5

6

2

4

1

2

0

0

-24-21-18-15-12 -9 -6 -3 0 3 6 9 12 15 18 21 24
Months before/after inflation peak
1956m41975m81980m5

25
20
15
10
5
0
-5
-10

2.5
2.0
1.5
1.0
0.5
0.0
-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8
1956Q1

Quarters before/after inflation peak
1956Q1
1975Q3
1980Q22022Q3

1975Q3

1980Q2-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8Quarters before/after inflation peak2022Q3

1956Q1

180

90

170

80

160

70

150

60

140
-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8130Quarters before/after inflation peak
1956Q1

1975Q3

1980Q2

7

1975Q3

1980Q22022Q3Credit from banks

Credit from all sectors
100

50-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 82022m103.0

GDP constant prices
30

1980m5

3.5

Quarters before/after inflation peak

2022m101975m8

Unfilled vacancies (% labour force)

83

1956m44.0

10

4-24-21-18-15-12 -9 -6 -3 0 3 6 9 12 15 18 21 24
Months before/after inflation peak

2022m10

Registered unemployment (% labour
force)

Unemployment rate
650Months before/after inflation peak2022Q3 (RHS)

50

100

45

95

40

90

35

85

30

-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 880

Quarters before/after inflation peak
1956Q1

1975Q3

1980Q22022Q3 (RHS)Germany
8
7
6
5
4
3
2
1
0
-1
-2

8
6
4
2
0
-2

-24-21-18-15-12 -9 -6 -3 0 3 6 9 12 15 18 21 24

8
7
6
5
4
3
2
1
0
-1
-2

-24-21-18-15-12 -9 -6 -3 0 3 6 9 12 15 18 21 24

1973m12

1981m101956m52022m104.0

3
1-24 -20 -16 -12 -8

-4

0

4

8

12 16 20 24

1973m12

1981m10

1956Q22022m10GDP constant prices

1973Q4

1981Q3

Quarters before/after inflation peak
1956Q22022Q3

10

4

80
75
70

110

2

65

100

0

60

90

-2
-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 880

Quarters before/after inflation peak
1981Q355
50-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8
1956Q2

1973Q4

1981Q3-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8Quarters before/after inflation peak

Quarters before/after inflation peak2022Q32022Q385

120

61981Q390130

81973Q4Credit from banks

Credit from all sectors
140

1973Q4-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8Quarters before/after inflation peak

12

1956Q2

2.5

0.0

0

Months before/after inflation peak
1956m52022m10

0.5

2

0.5

1981m10

1.0

4

1.0

1973m12

Unfilled vacancies (% labour force)

1.5

5

1.5

1956m5

2.0

6

2.0

Months before/after inflation peak

2022m10

7

2.5

-4

1981m10

8

3.0

0.0

1973m12

Registered unemployment (% labour
force)

Unemployment rate
3.5

-24-21-18-15-12 -9 -6 -3 0 3 6 9 12 15 18 21 24

Months before/after inflation peakMonths before/after inflation peak
1956m5Central bank rate

Core CPI

All items CPI
10

1956Q22022Q3

1973Q4

1981Q32022Q3

FranceAll items CPI
16
12
8
4
0
-4

-24-21-18-15-12 -9 -6 -3 0 3 6 9 12 15 18 21 24
1974m12

1981m112023m2

14
10
6
2
-2

-24 -20 -16 -12 -8
1958m5

Unemployment rate

-4

0

4

8

12 16 20 24

1974m12

1981m11

Quarters before/after inflation peak

7
6

240

8

130

230

6

120

220

110

210

2
-24 -20 -16 -12 -8

-4

0

4

8

12 16 20 24

Months before/after inflation peak
1958m51974m12

1981m11

0100-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8Quarters before/after inflation peak

2023m22023Q1250

451981Q4140

1081974Q4Credit from all sectors
150

12

9

-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8
1958Q22023m2

Registered unemployment (% labour
force)

10

4

18

Months before/after inflation peakMonths before/after inflation peak
1958m5GDP constant prices

Core CPI
16
14
12
10
8
6
4
2
0
-2

20

1958Q2

1974Q48

1981Q42023Q1-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8200

Quarters before/after inflation peak
1958Q2

1974Q4

1981Q42023Q1 (RHS)

Credit from banks
80

120

75

115

70

110

65

105

60

-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8100

Quarters before/after inflation peak
1958Q2

1974Q4

1981Q42023Q1 (RHS)

Source/note: see Box 1.

3. The real interest rate and its equilibrium value
What role could have recent monetary �ghtening played in the above-discussed macroeconomic
developments? To answer this ques�on, we scru�nise real interest rate developments compared tothe equilibrium value of real interest rates.
Conceptually, the real interest rate determines the savings and investment decisions of economic
actors, like households and companies. The real interest rate is deﬁned as the nominal interest rateadjusted for expected inﬂa�on. Inﬂa�on expecta�ons are unobserved variables and can beheterogeneous across agents. O�en, inﬂa�on expecta�ons are measured by ﬁnancial market
indicators, like inﬂa�on swaps, and from various surveys (professional forecasters, households,
corporates) – approaches that we also follow. Unfortunately, such �me series typically start in the
2000s, not allowing the comparison of the current monetary �ghtening cycle with earlier episodes.

3.1 Market-based real interest rates
Between the global ﬁnancial crisis and the COVID-19 pandemic, the 1-year real interest rates weregenerally nega�ve in the euro area, the UK and US (Figure 3). Japan is also included in the ﬁgure, butdata is available only from 2017. The lowest real interest rates were observed in the United Kingdom,
due to the highest inﬂa�onary expecta�ons, which were above 3% from October 2016 un�l the
pandemic. Real interest rates were moving up steadily before the pandemic in the United States andalso in Japan, while there was a more sudden upward shi� in the euro area, which resulted from afall in inﬂa�onary expecta�ons, while nominal interest rates stayed at nega�ve levels, close to the
ECB’s deposit facility rate. With the surge in inﬂa�on from 2021, real interest rates fell drama�cally,
especially at the 1-year horizon, nearing minus 8 percent in the United Kingdom, minus 6 percent in
the euro area, and minus 4 percent in the United States. More recently, with the increase in nominalinterest rates due to central bank �ghtening and the fall in expected inﬂa�on, real rates increased toposi�ve territories. The 1-year real interest reached 3 percent in the United States, 1.5 percent in theeuro area, and 2 percent in the United Kingdom, though more recently fell back to about half
percent. The 1-year real rate expected in 4 years from now, by when short-run shocks fade out andthe impacts of monetary policy are materialised, is around 1.5 percent in the United States, half
percent in the euro area, and close to zero in the United Kingdom (in the UK, inﬂa�on expecta�ons
are at 4% both in the short term and in 4 years from now). Thus, real interest rates increased tolevels seen in the pre-global ﬁnancial crisis period, which was also characterised by monetary�ghtening in several countries.

9

Figure 3: Financial market-based real interest rates (percent per year)
United Kingdom

United States

6

6
4

4

2
2

0
-2

0

-4

-2

-6
-4

-8

07/2023

07/2022

07/2021

07/2020

07/2019

07/2018

07/2017

07/2016

07/2015

07/201407/201307/201207/20111-year rate 4 years from now

07/201007/2009

07/2008

07/2006

07/2005

07/2004

07/2023

07/2007

1-year rate

-10
07/2022

07/2021

07/2020

07/2019

07/2018

07/2017

07/2016

07/2015

07/201407/201207/2013

1-year rate in 4 years from now
07/201107/201007/2009

07/2007

07/2006

07/2005

07/2004-6

07/2008

1-year rate

Japan

Euro area
4

1

2

0
0

-1

-2
-4

-2
-6

07/2023

07/2022

07/2021

07/2020

07/2019

07/2018

07/2017

07/2016

07/2015

07/201407/201307/20121-year rate 4 years from now
07/201007/2009

07/2008

07/2005

07/2004

07/2023

07/2022

07/2021

07/2020

07/2019

07/2018

07/2017

07/2016

07/2015

07/201407/201307/201207/201107/201007/2009

07/2008

07/2007

07/2006

07/2005

07/2004

07/2007

1-year rate

-3

07/20111-year rate 4 years from now

07/2006

1-year rate
-8

Source: Bloomberg.
Note: the last observation is 7 November 2023.

3.2 The natural rate of interest
The level and the changes in real interest rates should be best compared to the level and changes inequilibrium real interest rates. The equilibrium rate is an unobserved variable, and thus various
econometric models, based on diﬀerent assump�ons, have been used to es�mate such rates. Thesees�mates are characterised by uncertain�es, and only a few es�mates are available for more recent
periods.
A popular concept is the natural rate of interest, which is o�en denoted as r*. This indicator aims tomeasure the equilibrium value of the short-term real interest rate that is expected to prevail whenthe economy is opera�ng at its full sustainable level. Chapter 2 of IMF (2023a) es�mated such rates
for six advanced countries (Canada, France, Germany, Japan, United Kingdom, United States), using
the method of Holston, Laubach, and Williams (2017) – herea�er HLW. The full-sample es�matespresented in Figure 2.4 of IMF (2023a) suggest virtually unchanged r* from 2019 to the third quarter10

of 2022. The level of r* is es�mated to be slightly above 1% for Canada, France, the UK and the US,
somewhat above zero for Germany and below zero for Japan.
More recent es�mates, using data up to the second quarter of 2023, are provided by the Federal
Reserve Bank of New York 4 using two versions of the Laubach and Williams (2003) model (herea�erLW) for the United States, and the HLW model for the United States, euro area, and Canada. The
Federal Reserve Bank of Richmond 5 presents es�mates for the United States using the method of
Lubik and Mathes (2023) – herea�er LM.
The results from the four alterna�ve methods available for the United States display a large diversity,
both in terms of long-run trends and the level of the latest es�mates. LW and HLW suggest a longterm decline from 1961, though with occasional increases, while LM suggest a much lower star�ng
level in 1967 and some increases in the 1980s, before drops a�er the dot-com bubble burst in 2000
and the global ﬁnancial crisis in 2008. The latest es�mate for the second quarter of 2023 ranges from
0.6% (HLW) to 2.3% (LM), which is a rela�vely wide discrepancy. Moreover, each of these es�mates ischaracterised by considerable uncertainty.

Figure 4: Alternative estimates for the natural rate of interest (percent per year), 1961Q1-2023Q2

United States

54

LW (one-sided)
LW (two-sided)
HLW
LM

6
5
4
3

2

2

1

1

0

0

1961Q1
1966Q1
1971Q1
1976Q1
1981Q1
1986Q1
1991Q1
1996Q1
2001Q1
2006Q1
2011Q1
2016Q12021Q1

3

-1

HLW

-1

1961Q1
1966Q1
1971Q1
1976Q1
1981Q1
1986Q1
1991Q1
1996Q1
2001Q1
2006Q1
2011Q1
2016Q12021Q1

6Euro area

Sources: Federal Reserve Bank of New York and Federal Reserve Bank of Richmond.

Bäcker-Peral et al. (2023) highlighted the uncertainty of HLW es�mates, using data from the UnitedStates and the United Kingdom as an example. When post-2020 data is included, the HLW
methodology is destabilised by the steep decline in GDP in the second quarter of 2020 and the45

htps://www.newyorkfed.org/research/policy/rstar
htps://www.richmondfed.org/research/na�onal_economy/natural_rate_interest

11authors could not es�mate the model for the United States. For the United Kingdom, implausiblees�mates were made, ranging from -32.2% in the third quarter of 2020 to 25.9% in the second
quarter of 1975. The 95 percent conﬁdence band ranges from about -70% to +70% for the mostrecent observa�on. Bäcker-Peral et al. (2023) argue that data from the pandemic era not only aﬀects
the es�mates for the pandemic period, but also propagates to previous decades.
Most likely, Bäcker-Peral et al. (2023) used the pre-pandemic speciﬁca�on of the HLW model. The
update of LW and HLW es�mates was suspended from the start of the pandemic un�l May 2023 andonly the pre-pandemic replica�on code was available on the NY Fed website. With the re-launch of
the calcula�ons in May 2023, two main changes were made to the model (Williams, 2023; Holston,
Laubach and Williams, 2023). First, an addi�onal persistent supply shock related to the pandemic
was added, which is based on the Oxford COVID-19 Government Response Stringency Index for eacheconomy 6. Since the calcula�on of this stringency index was suspended in mid-2022, it is assumed
that in each country, it declines smoothly to zero over 2023-24 (Figure 5 of Holston, Laubach andWilliams, 2023). Yet whether this stringency index well approximates the possible shock to poten�al
output is not unques�onable, and in most countries, no more restric�ons are in place at the �me of
wri�ng, so the assump�on of a smooth decline over 2023-2024 likely exaggerates the impact of thepandemic in 2023-2024. The second modiﬁca�on was the introduc�on of a sta�s�cal procedure to
reduce the weight of periods when there are very large outliers in 2020-2022, based on a �mevarying process for the variance of the shocks hi�ng the economy. The necessity of introducing
these pandemic-related modiﬁca�ons to the model underlines that the es�mated natural rates
during and a�er the pandemic are burdened with even greater uncertainty than pre-pandemices�mates.
For the euro area, the only available up-to-date HLW es�mate suggests that the natural rateincreased somewhat to 0.7% by 2023Q1 and then fell to -0.2% by 2023Q2. The previous vintage ofthe es�mate, which used data up to 2023Q1, indicated that the euro area natural rate was 0.9% in
2023Q1. Thus, a new quarterly data point lowered past es�mates and suggested a major reduc�onof the natural rate in 2023Q2.
The econometric model for the natural rate also es�mates the output gap, which is deﬁned as thedevia�on of actual output from poten�al output. For the pandemic period, the new es�matessuggest a nega�ve output gap for a single quarter, 2020Q2, amoun�ng to -3.0% of poten�al output
in the United States and -4.7% in the euro area (Figure 5). The magnitude of this nega�ve output gap
is broadly similar to model es�mates for 1982 and 2009 for both the US and euro area, and for 1993
in the case of the euro area, implying that from the perspec�ve of demand shortages, the pandemic
recession was broadly similar to some earlier recessions. From 2020Q3, the es�mates show rather
large posi�ve output gaps both for the United States and the euro area, well above es�mates forearlier periods. This also implies that on average in 2020, the output gap was posi�ve both in the
United States and the euro area. While the output gap is an unobserved variable, and its deﬁni�onand es�ma�on are model-dependent, it is notable that the 2020-2023 HLW output gap es�matesdiﬀer substan�ally from other output gap es�mates. For example, the annual output gap es�matesfrom the IMF’s October 2023 World Economic Outlook for the years 2020-2023 are -2.5%, 1.5%,
1.4%, and 1.4% for the United States and -4.8%, -2.0%, 0.2%, and -0.4% for the euro area (IMF,
2023b). It thus seems that the way the pandemic shock is introduced in the HLW model resulted in a
major reduc�on of poten�al output in 2020-2023, far larger than in other es�mates.

6

htps://www.bsg.ox.ac.uk/research/covid-19-government-response-tracker

12Figure 5: Output gap estimates from the HLW model (percent of potential output), 1961Q12023Q28US

6Euro Area

4
2
0
-2
-4
-6
2021Q1

2016Q1

2011Q1

2006Q1

2001Q1

1996Q1

1991Q1

1986Q1

1981Q1

1976Q1

1971Q1

1966Q1

1961Q1-8

Source: Federal Reserve Bank of New York.

The wide range of natural rate es�mates and their large uncertainty, the diﬃcul�es in extending the
econometric model to the pandemic era, and major diﬀerences of natural rate model-implied output
gaps from other output gap es�mates all suggest that the econometric es�mates of the natural rateshould be assessed cau�ously.

3.3 The drivers of equilibrium real interest rates
The literature iden�ﬁed several factors that contributed to low real interest rates in the prepandemic era 7. Ul�mately, the real interest rate balances savings and investments, and thus higher
savings and lower investments can result in a fall in the real interest rate. Higher savings resulted
from:
•
•
•

•

higher income levels;
higher life expectancy, which encourages workers to save more of their income inan�cipa�on of their longer re�rement (Ferrero et al, 2017; Blanchard, 2023);
higher inequality in advanced countries, which increased the income of the rich – who arecharacterised by higher savings and a lower propensity to consume – and reduced at least
the rela�ve income (but in some cases even the absolute value of real income) of the middle
and poorer segments of the society – which have a greater propensity to consume;the ‘global savings glut’, that is, huge current-account surpluses accumulated by someemerging country governments (Bernanke, 2005).

Low investment in advanced countries could have resulted from:•7

low popula�on growth, which could translate into low future demand for goods andservices;

See a summary in Zetelmeyer et al. (2023).

13

•
•
•
•
•
•

slow produc�vity growth;
fall in the rela�ve price of durable equipment;a ﬁnancial sector which does not properly incen�vise investments;
monopoly posi�ons in some industries leading to huge rents and disincen�ves to increase
produc�on;
the reduced capital intensity of leading industries;
the decline in public investment a�er the global ﬁnancial crisis and the euro crisis.

Greater demand for safe assets issued in advanced countries could also have exerted downward
pressure on real interest rates:••�ghter pruden�al regula�ons adopted a�er the global ﬁnancial crisis required ﬁnancial
ins�tu�ons to hold safer and more liquid assets;
the global savings glut resulted in a large increase in the interna�onal reserves held by
emerging market countries, which were overwhelmingly invested in sovereign bonds fromadvanced countries.

Some of these factors might keep real interest rates low once the current inﬂa�on-induced central
bank �ghtening ends, as argued by Blanchard (2023). However, some interest rate-reducing
developments might be reversed, and some new considera�ons might suggest permanently higher
real interest rates in the future. In par�cular:••••

reserve accumula�on by emerging markets, most notably by China, has declined;
the re�rement age is gradually increased in many countries, which could dampen theincrease in savings;
increased bargaining power of low-income workers in advanced countries could reduceincome inequality in favour of households with a lower propensity to save;
investment demand could pick up due to:o reshoring in the a�ermath of the pandemic and amid geopoli�cal tensions;o development of new technologies;o climate change mi�ga�on;o public investment increases to meet new challenges, such as defence, digital andgreen transi�on.

Thus, conceptually, it is diﬃcult to conclude whether the era of low real interest rates will return, or
whether real interest rates will be signiﬁcantly higher than before the pandemic. To get a marketbased view of this issue, we look at real interest rate expecta�ons in the next sec�on.

3.4 The expected path of short-run and long-run real interest rates
An alterna�ve to econometric es�ma�on of the equilibrium real interest rate is an analysis of market
expecta�ons of future real interest rates. Presumably, markets do not expect speciﬁc cyclicalﬂuctua�ons in the economy many years ahead. If market expecta�ons many years ahead areconsistent with a balanced development of the economy, then real interest rates expected for the
future can be indica�ve of the equilibrium level of interest rates. A caveat is that some of the longterm drivers of the real interest rate, such as poten�al growth, demography, inequality, and savingsby oil expor�ng countries, as reviewed in the previous sec�on, could change over several years, inwhich case the current equilibrium real rate could be diﬀerent from the equilibrium real rate, say, ten
years from now.
14

To illustrate our calcula�ons, we start by depic�ng the expected path of the 1-year and 10-year
nominal interest rates in the United States, as well as expected annual inﬂa�on in the years to come(Figure 6). The 1-year nominal interest rate was close to zero in 2020 and increased above 5% by2023. Market expecta�ons suggest a fall in the 1-year nominal interest rate in 2024, and also
marginally in 2025, but a�er that, the 1-year nominal interest rate is expected to increase gradually.
In contrast, the 10-year nominal interest rate is expected to peak in 2024 at 5.6% and decline only
marginally in later years. Meanwhile, a�er the peak inﬂa�on in 2022, annual inﬂa�on is expected tofall in the range of 2-3% in the years to come (panel B of Figure 6).

Figure 6: The expected path of 1-year and 10-year nominal interest rates and inflation (percent per
year)
Panel A
Panel B

Expected path of US nominalinterest rates in October 2023

6

Expected path of US inflation in
October 2023

8
7

5

Inflation

6

4

5

3

4
3
1-year nominal interest rate2

10-year nominal interest rate

1
2040

2038

2036

2034

2032

2030

2028

2020

2026

0

2040

2038

2036

2034

2032

2030

2028

2026

2024

2022

2020

0

2024

1

2022

2

Source: Bruegel calculations based on Bloomberg data.
Note: average daily data from 2-10 October 2023 is used for the calculations.

To calculate the real interest rate, we subtract the expected future inﬂa�on from the expected futurenominal interest rate. For example, to calculate the expected 1-year real interest rate in 2025, we
subtract from the expected 2025 value of the 1-year nominal interest rate the expected 2026 valueof annual inﬂa�on (because the 2026 inﬂa�on expresses the increase in prices from 2025 to 2026, so
this should be compared to the 2025 nominal interest rate). To calculate the expected 10-year realinterest rate in 2025, we subtract from the expected 2025 value of the 10-year nominal interest rate
the average of expected annual inﬂa�on between 2026 and 2035 (because this average corresponds
to the expected inﬂa�on over the dura�on of a 10-year government bond issued in 2025).
A simple visual comparison of the two panels of Figure 6 suggests that markets expect a real interest
rate of over 2% in the United States in the years to come.
In order to document the changes in market real interest rate expecta�ons from the period before
monetary �ghtening started to today, we do the calcula�ons by collec�ng market expecta�ons fromtwo dates: the average of 1-30 June 2021 and the average of 2-10 October 2023. In June 2021,
inﬂa�on in the US was 4.0% in terms of PCE and 5.4% in terms of CPI; in the euro area, it was 1.9% interms of HICP; and in the UK, it was 2.5% in terms of CPI. These values were between 2 and 3
percentage points higher than half a year earlier. Thus, inﬂa�on had already started to increase by15

June 2021, but not par�cularly severely, and just limited central bank rate hikes were expected inJune 2021.
Following the low real interest rate during the pandemic, in June 2021, markets expected that the 1year US real interest rate would gradually increase to about -0.5% in the 2030s (yellow line in Figure7), while the 10-year real interest rate would just marginally exceed zero (orange line). These
expecta�ons were revised very signiﬁcantly upwards by October 2023: the long-run value of the 1year real interest rate is now seen close to 2% (blue line), while the 10-year real interest rate is
expected to stay close to 3% by the early 2030s, a�er which a marginal decline to about 2.5% by
2040 is currently foreseen (green line). The close to 2% expected long-run 1-year real interest rate isreasonably close to the 2.3% natural rate es�mate of Lubik and Mathes (2023) for the second
quarter of 2023, but considerably higher than the 0.6% natural rate es�mate of Holston, Laubach,and Williams (2017) for the same quarter.
If these market expecta�ons indeed reﬂect the long-run equilibrium level of the real interest rate,then the cumula�ve 5.25 percentage point interest rate hikes of the Federal Reserve from March2022 to October 2023 have just moved the real interest rate from an expansionary status to a neutral
status, but the interest rate has (not yet) became contrac�onary. This could explain why the US
economy and labour markets remained resilient to these interest rate hikes.
Real interest rates also increased considerably in the UK from June 2021 to October 2023. However,
because of rather pessimis�c inﬂa�onary expecta�ons (over 4% inﬂa�on up to 2029, and s�ll 3.3%
inﬂa�on in 2040), the 1-year real interest rate is expected to remain just slightly above zero �ll 2029
and then gradually increase to 1.6% by 2040. The 10-year real interest rate, on the other hand, is
expected to reach 2% in the second half of the 2030s and remain marginally above 2% in the 2030s.
The conclusion about monetary �ghtening in the UK is similar to our conclusion for the US: thenominal rate hikes have just pushed real interest rates (Figure 3) close to values expected by themarket in the long run (Figure 7), and thus monetary policy moved from being expansionary to
broadly neutral. This, again, can explain why UK labour markets also remained resilient.
For the euro area, we report both the German real interest rate and the euro area average, though
the diﬀerences between the two are not considerable, as expected. In June 2021, markets
an�cipated nega�ve real interest rates to prevail in the next decades, with the German 1-year yieldreaching -1.7% and 10-year yield -1.3% by 2040. For the euro area, these June 2021 real rate
expecta�ons were -1.6% and -0.8%, respec�vely. These expecta�ons were revised upwards by
October 2023, with both 1-year and 10-year real rates moving to posi�ve territories – more so forthe euro area on average than for Germany. For the euro area, the close to 1% current real interest
rates (Figure 3) are just slightly above the expected longer-term real interest rate (Figure 7). Thus, it
seems that the ECB reached a marginally contrac�onary level of the real interest rate, which might
restrain economic growth and labour markets somewhat. Yet, during most of the period of monetary�ghtening, the monetary policy stance was s�ll expansionary, which could explain why labour
markets remained strong so far in the euro area too.

16

Figure 7: The expected path of 1-year and 10-year real interest rates in June 2021 and October
2023 (percent per year)

2040

2038

2036

2034

2032

2040

2038

2036

2034

2032

2030

2028

2020

2026

-8
2024

-8
2040

-6
2038

-6

2036

-4

2034

-4

2032

-2

2030

-2

2028

0

2026

0

2024

2

2022

Euro-area real interest rates

2

2022

2030

GBR_REAL_RATE_1Y_JUN_2021
GBR_REAL_RATE_10Y_JUN_2021
GBR_REAL_RATE_1Y_OCT_2023
GBR_REAL_RATE_10Y_OCT_2023

German real rates

2020

2028

2020

USA_REAL_RATE_1Y_JUN_2021
USA_REAL_RATE_10Y_JUN_2021
USA_REAL_RATE_1Y_OCT_2023
USA_REAL_RATE_10Y_OCT_2023

2026

-8
2022

-8
2040

-6
2038

-6
2036

-4

2034

-4

2032

-2

2030

-2

2028

0

2026

0

2024

2

2022

2

2020

UK real interest rates

4

2024

US real interest rates

4

EUR_REAL_RATE_1Y_JUN_2021
EUR_REAL_RATE_10Y_JUN_2021
EUR_REAL_RATE_1Y_OCT_2023
EUR_REAL_RATE_10Y_OCT_2023

DEU_REAL_RATE_1Y_JUN_2021
DEU_REAL_RATE_10Y_JUN_2021
DEU_REAL_RATE_1Y_OCT_2023
DEU_REAL_RATE_10Y_OCT_2023

Source: Bruegel calculations based on Bloomberg data.
Note: average daily data from 2-10 October 2023 and average daily data from 1-30 June 2021 are used for the
calculations.

4. Conclusions
Inﬂa�on in most advanced economies rose sharply along with the recovery from the COVID-19
pandemic recession, yet no forecaster foresaw that inﬂa�on could reach close to 10% values, well
above the 2% inﬂa�on target of central banks. Both demand and supply factors contributed to theinﬂa�on surge. The Bank of England, the European Central Bank, and the Federal Reserve started to�ghten monetary policy belatedly, not un�l inﬂa�on had reached values of several mul�ples of theinﬂa�on target. The belated start could be explained by the diﬃculty of leaving behind the “low forlong” narra�ve, the uncertainty about the contribu�ons of supply shocks to inﬂa�on, and the17apparently anchored long-term inﬂa�onary expecta�ons. Flawed forward guidance by the European
Central Bank also contributed to the belated start.
The interest rate increases by the Bank of England, the European Central Bank, and the Federal
Reserve since the post-pandemic inﬂa�on surge were rela�vely large from a historical perspec�ve.
However, despite these large rate increases, labour markets remain strong, as reﬂected in historically
low unemployment rates and con�nued job crea�on. Recessions have been avoided so far, incontrast to earlier episodes of monetary �ghtening. The good economic and labour market
performance in light of signiﬁcant interest rate increases is puzzling, and even more so if we take into
account global shocks and uncertain�es, such as the war in Ukraine and China’s slowdown.
We argue that a possible explana�on for this anomaly can be the extent of monetary �ghtening:
moving from a highly accommoda�ve monetary policy stance to a broadly neutral (but notcontrac�onary) monetary policy stance by the �me of wri�ng. We document that the real interest
rates were highly nega�ve in the years before the pandemic, and real rates fell further during the
pandemic. Since then, real interest rates increased substan�ally, but only to levels which can be close
to an equilibrium level. We argue that various es�mates for the natural rate of interest are
unreliable, yet for the United States, the highest natural rate es�mate is similar to the current actual
real interest rate. By analysing market expecta�ons for the future path of real interest rates, wedocument that markets expect the current level of real interest rates to persist for many years,
sugges�ng that current rates could be close to their equilibrium values.
The main implica�ons of our study are that (1) unless central banks will signiﬁcantly �ghten further,monetary policy is unlikely to exert a signiﬁcantly nega�ve eﬀect on the economy, (2) the reduc�onof core inﬂa�on might prove to be challenging, while headline inﬂa�on falls along with a decline inenergy prices, and (3) high nominal interest rates might persist for long.

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18

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19