The economy’s natural or equilibrium rate of interest can be defined as the real interest rate defined as the real interest rate that would hold aggregate economic activity at its potential level (i.e. the estimated level of output when all resources are employed at maximum capacity) and inflation at the monetary authority’s target level. The natural rate of interest cannot be observed. Instead, it is estimated on the basis of various data and observable factors.
Current estimates of the euro area’s real natural rate of interest suggest that it has decreased in recent decades to stand at slightly negative levels (around -1%). Since the European Central Bank (ECB) has a 2% inflation target, the nominal natural rate of interest would stand at around 1%. The main factors behind this decline in the equilibrium interest rate are population ageing, the higher saving ratio after the financial crisis and lower productivity growth.
When implementing monetary policy, central banks must bear in mind these estimates of the natural rate of interest because, to stabilise inflation at its target, they must try to keep interest rates close to their natural level. When central banks raise their policy interest rates such that interest rates rise above the natural rate of interest, economic growth slows and inflation tends to fall. Conversely, when central banks lower their policy interest rates such that interest rates fall below the natural rate of interest, economic growth picks up and inflation tends to rise.