March 29, 2004
The concept of the “natural” long-term interest rate, a rate that is determined by the underlying production capability of the economy, provides a way to check the internal onsistency of medium-term economic projections. Forecasters who use a neoclassical growth model to project the level of real Gross Domestic Product, as does the Congressional Budget Office, are implicitly projecting the natural rate, because the growth model simulates the production capability of the economy. The assumptions that are embedded in the growth model can be used to calculate the natural rate. In addition, economists have long noted that medium-term changes in inflation are related to the degree the natural rate is above or below people’s expectations about the inflation-adjusted rate of return they will get on financial instruments. If the natural rate is above the expected real rate, inflation will tend to increase; if below, it will decrease. Therefore, the natural rate concept links the assumptions of the growth model, the projected change in the rate of inflation, and the projected change in the rate of interest.