The neutral rate(s) of interest : linchpin between monetary and fiscal policies

The natural, equilibrium, or neutral Interest rate - or short r* - has been controversial among economists ever since it was introduced almost 150 years ago. As a conceptual tool that cannot be directly measured but only estimated by models, its value depends on the relevance for explaining economic phenomena and serving as a tool for orienting economic policy - not only monetary but also fiscal and structural policies. The article introduces the various concepts of r* as well as stylized empirical facts on their evolution, before teasing out their relevance for policy. For monetary policy, r* can serve as a tentative guidepost. As a low r* makes it more likely that the effective lower bound on interest rates is reached, it furthermore affects the likelihood of the need for unconventional monetary policy (thus influencing the monetary policy toolkit). In addition, r* can inform the choice of the welfare-optimal inflation target. But monetary policy itself also affects r*, thus calling for caution in the use of r* as a guidepost and in the use of highly expansionary unconventional monetary policies over long periods. For fiscal policy, r* affects debt sustainability and thus the fiscal space for countercyclical policy and addressing long-term structural challenges. Conversely, r* itself is strongly affected by fiscal and structural policies and public debt. r* thus can be viewed as a linchpin in the interplay between fiscal, structural and monetary policies. While the jury is still out, it is likely that after its recent post-covid upward reversal, r* will remain at levels above the pre-covid period. The prevalence of negative supplyside shocks and high public and private borrowing to finance climate protection, defense, the digital transformation and the costs of ageing as well as impediments to international financial flows would support higher real interest rate levels. We argue that a rise in r* is desirable: it would help to regain monetary policy space without having to resort to unconventional monetary policies with their multiple side effects. It would help encourage fiscal discipline and avoid resource misallocation for inefficient excessive public spending and unproductive private investment.