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Full research· The study estimated the short-term natural interest rates of Israel, Sweden, and Canada. The study shows that in all three countries, the natural interest rates declined sharply during the Global Financial Crisis in 2007-2008, and then increased, although to levels lower than the precrisis levels.
· It was also found that monetary policies in those three economies during the decade following the GFC were accommodative and supported real activity and price stability.
· In Israel, policy was also accommodative when the Bank of Israel’s monetary interest rate was at its effective barrier.
The natural interest rate is a theoretical term, but it has important practical implications for the design of monetary policy, and therefore also for its conduct. The natural interest rate is a real interest rate that leads to equilibrium, in which GDP is at its potential level (zero output gap) with price stability (the inflation rate is at its target)—the two declared goals of monetary policy under an inflation targeting regime.
If the real interest rate (the central bank interest rate minus inflation expectations) is lower than the natural interest rate, it means monetary policy is accommodative relative to economic activity. Alternatively, if the real interest rate is higher than the natural interest rate, it means that policy is restrictive. This is where the importance of the natural interest rate as an indicator for monetary policy makers come into play, since it serves as a real anchor for the monetary interest rate.
The main problem is that the natural interest rate is unobserved, and must therefore be estimated. A study by Alex Ilek and Guy Segal of the Bank of Israel Research Department proposes a simple and innovative method for estimating the short-term natural interest rate for open economies. According to the economic literature, the natural interest rate in open economies is connected to the expected growth of potential GDP and expected output growth of the economy’s trading partners. The study uses data and assessments regarding expectations for these two components, and derives the natural interest rates in three open economies—Israel, Canada, and Sweden—from the interest rate rule of each country’s central bank. The commonality of these three economies is that they are advanced economies with an inflation target regime that has been established for many years, and mainly that they are characterized by a high level of openness toward the rest of the world, both in terms of trade in goods and services and in terms of financial openness toward the global market. The research on Canada and Sweden was made possible thanks to fruitful cooperation between the Bank of Israel Research Department and those of the central banks in those countries, which enabled access to essential data on those economies, some of which is restricted from the general public.
The main innovation in the method presented in the study is that the natural interest is derived from just one equation – the central bank’s interest rate rule. This is in contrast to commonly accepted methods that derive the natural interest rate from rich models that include all components of the economy. The advantage of using the interest rate rule is that there is unanimity in the literature concerning its specification, which results in low uncertainty of the natural interest rate estimation derived from it. This is in contrast to the very high uncertainty regarding the proper model of the economy. The second innovation in the study is that it uses observed variables of factors that influence the natural interest rate, which also reduce the uncertainty surrounding the estimation of the natural interest rate, without needing to derive them with complex statistical tools that require many assumptions, such as the “Kalman filter”, as is common in the literature.
Since the natural interest rate in the study is estimated together with the central bank’s interest rate rule, the estimation of the natural interest rate captures the monetary committee’s assessments of the natural interest rate and not necessarily the “true” natural interest rate in the economy, which has an impact on real activity. The study presents strict examinations of the estimation of the natural interest rate for the three economies that was studied (Israel, Canada, and Sweden), in order to make sure that it is a good and relevant estimation of real activity and of the monetary stance.
The study finds a similar natural interest rate dynamic in all three countries up to 2019. The rate declines during crises or recessions and increases during economic booms. It should be noted that the research method is appropriate for routine times or slight-to-moderate crises, but is not appropriate for periods of serious crisis such as the COVID-19 crisis, a crisis that is unique in terms of its intensity, its duration, and its nature. In order to analyze the natural interest rate during the COVID-19 crisis, a methodology that relates to all of the unique elements experienced by the Israeli economy during the crisis in 2020-2021 is necessary.[1]
The study shows that after the natural interest rates declined sharply during the Global Financial Crisis—in 2007 and 2008—they then increased, although to a lower level than they had been prior to the crisis. This reflected the expectation of lower growth rates following the crisis than the precrisis rates. In addition, the study found that monetary policy in the three economies in the decade following the crisis was accommodative and supported real activity and price stability. This was reflected in the fact that the real central bank interest rate was lower than the natural interest rate for most of the period. In Israel, policy was also accommodative during the period when the Bank of Israel’s monetary interest rate was at its effective barrier. An effective barrier means that the monetary interest rate is at a low level, and that the monetary committee feels that lowering it further will not necessarily stabilize activity, inflation, or other policy goals, and may even cause a significant increase in financial asset prices and create risks to the financial system. In view of the fact that the Bank of Israel interest rate was at its effective barrier between 2015 and 2018 (part of the sample period), the study presents a special econometric discussion to properly estimate the Bank of Israel’s interest rate rule, which also has implications for the quality of the estimation of the natural interest rate.
[1] An analysis of the natural interest rate during the COVID-19 crisis in Israel appears in the chapter on the natural interest rate in a book on price stability that is expected to be published in mid-2022.