Olli Rehn: Whither r*? The outlook for the natural rate of interest
under short-run inflationary pressures and structural shifts
Policy keynote speech by Mr Olli Rehn, Governor of the Bank of Finland, at the Bank of
Finland and CEPR Joint Conference 'Monetary Policy in Times of Large Shocks',
Helsinki, 16 June 2023.
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Ladies and Gentlemen, Dear Friends,
It is my great pleasure to welcome you to Helsinki and to this timely conference on
"Monetary Policy in Times of Large Shocks", jointly organized by the Bank of Finland
and the Centre for Economic Policy Research.
Last year at the time of this conference, we were in the middle of the energy crisis
caused by Russia's unjustified war against Ukraine. Euro area inflation had just risen
above 8% and the growth outlook had turned highly uncertain.
Much has happened since then, also in monetary policy. The ECB has acted
consistently to bring inflation back to its target. The key interest rates have been raised
8 times by a total of 4 percentage points, latest yesterday by 25 basis points. The
ECB's key policy rate is now at 3.5 percent.
Euro area inflation has proved more persistent than expected despite falling energy
prices and easing supply bottlenecks. The persistence of inflation is due to gradually
increasing labor costs, which are becoming a dominant driver of inflation. However, with
energy inflation set to become increasingly negative through 2023 and food inflation
somewhat moderating, headline inflation is expected to continue its decline towards
2.2% in 2025, as forecasted by Eurosystem staff.
Euro area economic activity broadly stagnated at the turn of the year but has remained
quite resilient. Consumers are still benefitting from savings accumulated during the
pandemic. Uncertainty over energy prices has declined and fiscal easing measures
have partly compensated the loss of real income due to high inflation. At the same time,
supply bottlenecks have almost vanished.
The Governing Council's future decisions will continue to follow a data-dependent
approach. They will ensure that the key ECB interest rates will be brought to levels
sufficiently restrictive to achieve a timely return of inflation to the 2% medium-term
target and will be kept at those levels for as long as necessary.
* * *
Dear Friends,
This outlook, however, calls for a longer-term perspective. Once inflation has been
aligned with the 2% target, will interest rates remain at higher levels - once coined
"normal" - in a more permanent manner? Or should we expect the persistently low
interest rates, observed post-2008, to return and be our "new normal" again? This
obviously depends on the natural rate of interest, or r* in short.
The natural rate of interest is the real interest rate that supports the economy at
maximum output and full employment while keeping inflation constant. It is the
equilibrium rate and dividing line between expansionary and contractionary monetary
policy. Essentially, it is determined by structural factors, which, however, can be
overturned at times by transitory economic shocks.
This observation has two major policy implications.
Firstly, a structurally low r* does not rule out temporary episodes of high inflation.
Transitory shocks can generate persistent inflationary pressures, which - if not
counteracted by monetary policy - entail the risk of high inflation through the feedback
of expectations and wages. This underscores the importance of the ongoing monetary
tightening and of the commitment to restore low and stable inflation.
Secondly, transitory high inflation and a structurally low r* can coexist. In other words,
an episode of high inflation alone does not necessarily imply the reversal of low r* over
longer horizons. Even though it may be tempting to extrapolate the current situation to
the future, we cannot assume that it automatically marks the end of the long-standing
secular decline of the natural rate.
So, whither r* - what should we think about it at this point?
Assessing its level is challenging as it is unobservable and can only be estimated.
When thinking about whether the natural rate has remained low, we need to look at the
factors which were believed to have caused the low level. Factors typically viewed as
important include demographic change, an increase in inequality and the slowdown in
productivity growth. These demonstrate that the secular drivers of r* are inherently
structural, which is why a major reversal in just a few years seems unlikely.
We thus have reason to assume, at least as a baseline, that the natural rate will remain
close to the pre-pandemic levels once the current inflationary pressures subside. This
implies that the challenges for monetary policy, particularly from the effective lower
bound, are likely to persist. This underlines the importance of strategic reviews
conducted by central banks just before the inflationary shocks.
This view on the natural rate is also shared more broadly, as reflected in the most
recent IMF world economic outlook and in the Fed's recent update of the
HolstonLaubach-Williams estimate of r*. This measure suggests its level for advanced
economies would hover around 1% or somewhat below currently.
* * *
While abrupt reversals of the secular drivers of r* are unlikely, the economies have
nonetheless been undergoing several important shifts. One of these concerns
productivity growth.
Discussion on a potential reversal of the productivity slowdown emerged at the onset of
the COVID-19 crisis when hopes surfaced that firms would increase digitalization and
thus boost productivity. While the use of digital communication technologies and remote
work has indeed transformed working life, the productivity effects of these changes are
currently assessed to be rather small.
The pandemic may also have weighed on investment in innovation. For instance, euro
area business R&D investment decelerated in 2020. If this downward adjustment in
investment is pronounced, it could lead to a deceleration of growth in the economy
through hysteresis effects on total factor productivity, at least in some countries.
The energy crisis, triggered by Russia's illegal and brutal war in Ukraine, is another
major recent shift. While higher energy prices can sustain inflationary pressures through
second round effects and potentially weigh on economic activity more broadly, the
related green transition may generate productivity gains over longer horizons. This
would apply particularly if the transition to cleaner energy fosters a wave of green
innovation with positive externalities for the wider economy.
Another ongoing structural shift with monetary policy implications is the increased use
of artificial Intelligence (AI). To the extent that AI constitutes a general-purpose
technology, like, for instance, personal computers, its potential productivity effects may
be immense.
The impact of AI on the natural rate of interest is highly uncertain at this point but will
most notably depend on the labour market response. In contrast to previous
disruptions, AI holds the potential to displace workers across the skill and income
distribution, including high-skilled workers.
Perhaps the most important challenge posed by AI is the potentially significant increase
in inequality between displaced workers and those remaining in employment and
benefiting from AI in a labor-augmenting way. This potential intensification of inequality
could further weigh on the natural rate.
In addition to the structural shifts shaping r*, we have to be mindful of the risk of new
shocks emerging that may move the natural rate in either direction. For instance,
geopolitical tensions could intensify deglobalization and geoeconomic fragmentation,
which would also be reflected in r*.
Another key challenge is high public debt. The long-term trajectory of r* is a crucial
determinant of fiscal sustainability, while unsustainable public debt may raise the
natural rate.
In sum, current information suggests that the natural rate is likely to hover close to the
pre-pandemic levels. This said, what is certain is that the ongoing secular shifts and the
risk of new shocks leave the outlook for r* highly uncertain.
In any case, policy makers need to form an opinion on r* and long-term real rates. How
can this challenge be addressed?
In my view, policy makers and researchers need to be guided by the following three
principles: modesty, openness and flexibility .
As to modesty , researchers should acknowledge the limitations and the uncertainty
regarding both the underlying assumptions and the estimates of the natural rate.
Policymakers, in turn, may have to depart from the expectation of basing their decisions
on the point estimates of r*. Failing to acknowledge the high degree of uncertainty
underlying r*, we risk ending up with false perceptions and policy biases.
The second principle, openness , may help address these challenges. As the
underlying drivers of r* appear too complex to be compressed into a single estimate,
assigning a path for the natural rate by following a broad-based and data-based
approach may be a more effective approach. For instance, we may want to explore new
indicators, such as measures of innovation activity, to gain a timely view on TFP growth.
A close and continuous dialogue between research and policy is crucial in this context.
This conference provides an excellent example in this regard, as it features invited
speeches and sessions that are highly policy relevant, covering key challenges for
monetary policy and topical themes in e.g. fiscal policy, robotics, and wage inequality.
When it comes to the third principle, flexibility will remain essential in forming views on
the future of r*. Most notably, flexibility is warranted to adjust our views on the natural
rate over time, when new signals from its underlying forces emerge.
To conclude, estimates of the natural rate of interest r* can, to some degree, serve as a
point of orientation, if policymakers acknowledge that they are only summary statistics,
which distil certain aspects of the data and are subject to the underlying assumptions
and uncertainties.
Measures of the natural rate should thus serve as only one of many sources of
information that monetary policy should draw on when forming a view on the
longerterm outlook for real interest rates.
Monetary policy should also acknowledge that r* is bound to change over time. This
means that assessing the longer-term outlook for real interest rates should be
considered a continuous process rather than a one-time, post-crisis stocktaking event.
Let me also stress that these principles - modesty, openness and flexibility - are
essential at the current juncture, where short-run transitory forces, on one hand, and
long-run secular drivers, on the other hand, are pulling r* in opposite directions.
Ladies and Gentlemen,
With these words, let me wish you a pleasant stay in Helsinki and a very productive and
insightful conference. I hope that our long June days contribute both to your business
and pleasure.
Thank you very much for your attention.