The Natural Rate of Interest Foretells America’s Fiscal Doom

The idea of a “neutral” or “natural” rate of interest looms over discussions of US monetary policy. Whether it’s any help in setting the course of monetary policy is questionable. Yet there’s no doubt it belongs at the center of a different, equally important discussion — on the sustainability of public debt. In that context, it gets far too little attention.

Briefly, using the neutral rate as a starting point for setting the Federal Reserve’s policy rate is unhelpful. You can define that idea in many different ways; however you define it, it’s hard to measure. Put simply, it’s the interest rate that balances saving and investment with stable inflation and no transitory shocks. Observers infer the Fed’s estimate of this number from the periodic “dot plot.” Beyond 2028, the central bank expects inflation to be back on target at 2% with the federal funds rate at 3%. So, the Fed thinks the neutral policy rate, in due course, will be 3% in nominal terms, or 1% after adjusting for inflation.