## CHAPTER 2

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---

### Introduction and context
- Historical episodes show the same real interest rate can be stimulatory or contractionary relative to a changing reference level:
  - In 1979, the Federal Reserve hiked nominal rates from about 10 percent to almost 14 percent; in real terms this was about 5 percent. Inflation peaked at nearly 15 percent the following year.
  - After the 2008 global financial crisis, central banks cut nominal and real rates toward zero; inflation remained low for much of the following decade.
- Macroeconomic interpretation:
  - The natural rate of interest is the real rate that is neither stimulatory nor contractionary and is consistent with output at potential and stable inflation.
  - The natural rate is driven by real phenomena such as technological progress, demographics, inequality, and preferences for safe and liquid assets.

### Key questions addressed
- How has the natural rate evolved across economies?
- What has driven that evolution?
- What is the outlook for drivers and natural rates in the near and medium term?
- How will the outlook affect monetary and fiscal policies?

### Approach and methodology
- Two-pronged estimation strategy:
  - A simple, data-driven model (Laubach and Williams 2003 / HLW) to let the data speak.
  - A tighter theoretical structure (Platzer and Peruffo 2022 / PP) to impose more restrictions and quantify underlying drivers.
- Comparison across models provides independent validation.
- Alternative scenarios for plausible future developments of main drivers are considered for robustness and to anchor long-term policy and debt-sustainability analysis.

### Main findings (summary)
- Common trends contributed importantly to declining real interest rates:
  - The natural rate has declined over the past four decades in most advanced economies and some emerging markets.
  - Demographic transitions and productivity slowdowns are key synchronized drivers; idiosyncratic factors explain cross-country differences.
- Global drivers produced offsetting forces with limited net impact:
  - Integration of global capital markets and fast-growing emerging markets pushed in opposite directions: high emerging-market growth raised advanced-economy rates while a glut of savings in emerging markets increased demand for safe liquid assets and pushed natural rates down in advanced economies.
  - On balance these forces broadly offset, producing a moderate net impact on natural rates over the past half-century.
- Convergence prospects:
  - Under conservative assumptions on demographics, fiscal, and productivity developments, country-specific natural rates are projected to converge in the next couple of decades, with large emerging-market economies’ natural rates declining toward low and steady advanced-economy levels.
- Policy constraints and implications:
  - As inflation returns to target, the effective lower bound (ELB) on nominal interest rates may become binding again.
  - ELB could limit central banks’ ability to respond to negative demand shocks; debates about the appropriate inflation target at the ELB may reopen.
  - Some emerging-market central banks may need unconventional policy tools similar to those used by advanced economies.
- Fiscal implications:
  - Low natural rates increase fiscal space, but many countries still need fiscal consolidation to ensure long-term debt sustainability.
  - Delaying consolidation increases required adjustment; larger public debt can crowd out private investment and erode the appeal of safe and liquid government debt.

### Stylized trends in real rates
- US real rates across maturities:
  - Ex ante and ex post measures at 1-year, 2-year, 5-year, 10-year, and 20-year horizons all show a common long-term trend: real rates have fallen steadily by about 5 percentage points over the last four decades across maturities.
- Cross-country advanced-economy patterns:
  - Three-month real rates for selected advanced economies (United States, Japan, Germany, United Kingdom, France) show a steady decline from highs in the 1980s, growing international commonality and gradual convergence.
- Advanced vs emerging markets:
  - Aggregated ex post real interest rates (sample: 34 advanced economies and 25 emerging market and developing economies; maturities > one year; nominal rates deflated by consumer price inflation) display a shared trend at the start of the 2000s that decouples after 2011:
    - Real rates continued to decline in advanced economies.
    - Real rates stabilized at their 2005 level in emerging markets.
  - The divergence suggests frictions preventing stronger convergence despite broadly balanced current accounts.

### Measuring the natural rate
- Rationale:
  - The natural rate is unobserved; measurement uses macro relationships among supply, demand, interest rates, and inflation.
- Single-country HLW estimates:
  - HLW defines the natural rate as the real rate that returns output to potential and inflation to target once transitory shocks dissipate.
  - Decomposes changes into:
    - A component due to changes in long-term trend growth.
    - A component due to other factors (domestic and foreign).
  - Limitations:
    - Best suited to advanced economies with long data series consistent with New Keynesian dynamics.
    - Uncertainty is large because relationships between interest rates, the output gap, and inflation are relatively weak.
- Empirical HLW results (selected advanced economies):
  - Over two five-year periods (end of the 1970s and late 2010s) the natural rate declined across advanced economies by a little over 2 percentage points in most countries.
  - The HLW decline is smaller than the roughly 5 percentage point decline in observed real rates, reflecting changing monetary policy stances (notably tighter policy in the early 1980s).
  - Confidence intervals are wide; for the United States the 90 percent confidence interval in the second half of the 2010s ranges from zero to about 3 percent.
  - The trend growth component is better estimated (narrower confidence intervals) because output data are directly informative about trend growth.
  - Except for Japan, the drop in the natural rate exceeds what is implied solely by changes in trend growth, implying additional forces.

### Canada — estimated natural rate, pandemic dynamics, and multicountry spillovers
- HLW Kalman-filter estimates for Canada are reported alongside other advanced economies; estimated natural rates are more similar across countries now than 40 years ago, reflecting increased capital market integration.
- HLW closed-economy estimates are useful benchmarks but cannot capture international spillovers explicitly, motivating multicountry extensions.
- Natural rate during the COVID-19 pandemic:
  - Contemporaneous HLW estimates early in the pandemic often implied an exceptionally low natural rate because the model interpreted large supply shocks as persistent.
  - Full-sample (up to 2022:Q3) estimates revised away much of the sharp early-pandemic decline; policymakers who looked through the crisis and applied judgment delivered moderately stimulatory policy.
  - Later in the pandemic, policy loosened largely because inflation eroded real policy rates; contemporaneous and full-sample estimates converged by that stage.
- Multicountry HLW extensions (two-region Wynne and Zhang 2018 style):
  - US natural rate declined by about 2 percentage points in the past 50 years; the rest-of-world natural rate has been more stable since the mid-1970s.
  - Two international channels:
    - Overseas growth supported the US natural rate.
    - “Other factors” (increasingly negative for the US) reflect higher foreign demand for safe, liquid US assets depressing returns.
  - Multicountry estimates are imprecise: confidence bands are large and the exercise is not disciplined by current account data.

### Taxonomy of drivers and mechanisms
- Macroeconomic drivers (long-term relevance):
  - Productivity growth: higher productivity raises the natural rate via higher marginal product of capital.
  - Demographics: fertility and mortality changes affect growth, dependency ratios, and aggregate desired saving.
  - Fiscal policy: increased government borrowing can raise interest rates via private investment displacement.
  - Market power and labor share: ambiguous net effect; distributional channels and cohort impacts matter.
  - Other macro channels: taxation effects, rising inequality increasing aggregate saving, and interactions among channels.
- Financial drivers (short- to medium-term relevance):
  - International capital flows and safe-asset scarcity: high-growth emerging markets can push advanced-economy natural rates up via capital outflows, while a shortage of safe liquid assets (notably US government bonds) can depress returns.
  - Risk aversion and leverage cycles: convenience yields on safe assets rise in stress, strengthening safe-haven demand (especially for US Treasurys).

### The PP structural framework (Platzer and Peruffo 2022) — calibration and scope
- PP is a “real” model that unifies multiple mechanisms to quantify contributions to the natural rate while avoiding double-counting from separate calibrated models.
- Abstracts from nominal/financial frictions and uncertainty but allows foreign developments to affect domestic rates via net international capital flows.
- Calibration covers eight major economies: the United States, Japan, Germany, the United Kingdom, France, China, India, and Brazil — collectively covering some 70 percent of global GDP.
- Model inputs include demographics, age-earning profiles, share of income to the richest 10 percent, productivity trends, retirement age, average pension replacement rates, labor share, government debt, and public expenditure.

### PP model findings on the historical decline in natural rates (1975–79 to 2015–19)
- No single factor dominates the past 40-year decline; a set of common forces explains part of international comovement.
- Population aging contributed negatively to the natural rate in all eight countries; the effect was particularly large in China, Japan, and Germany.
- TFP growth declined in all advanced economies and sometimes explained more than the final decline in the natural rate.
- Fiscal policy often acted as an offset:
  - Japan: public debt increased by more than 200 percent of GDP, lifting the natural rate by more than negative contributions from TFP growth or demographics.
  - Brazil: a large increase in public consumption financed by taxation explains a positive fiscal contribution; increases in public debt also play a role.
- Net international capital flows were a significant but smaller contribution:
  - The largest net negative effect is found in the United States — consistent with emerging-market demand for safe assets more than offsetting capital outflows to attractive foreign investments.
  - In Japan, capital outflows dominate, lifting its natural rate as excess domestic savings are invested abroad.
- PP and HLW frameworks produce strikingly similar overall declines in the natural rate, providing cross-method reassurance.

### Outlook for the natural rate — baseline and scenarios
- Baseline assumptions:
  - Demographics follow United Nations population projections.
  - Public debt follows WEO projections until 2028 and remains constant thereafter.
  - All other drivers fixed at 2015–19 levels.
  - In emerging markets, TFP growth converges to the advanced-economies’ average over the long term.
- Baseline projections:
  - Natural interest rates likely stay close to pre-pandemic levels in advanced economies.
  - Emerging markets: significant declines projected because of slowing productivity growth and accelerating demographic transitions.
  - Example: China is projected to have a steady decline in the natural rate by about 1.5 percentage points within the next 30 years, bringing it to about zero in 2050.
  - Assumes some degree of segmentation between advanced and emerging market capital markets and that the balance of capital inflows/outflows stays as in 2019.
- Alternative scenarios (deviations from baseline):
  - Overall expected deviations span about 120 basis points centered on the baseline; larger effects possible from combined scenarios.
  - Higher government debt:
    - Allowing public debt to increase by 25 percent of GDP above the baseline by 2050 would increase demand for private savings and lift the natural rate.
    - Modeled impact should not exceed 5 to 10 basis points for most countries.
  - Erosion of the convenience yield (advanced economies):
    - If the premium for safe, liquid government debt erodes to pre-2000 average levels, natural rates in advanced economies and lower corporate bond yields would rise by about 70 basis points.
    - A full reversal of large foreign portfolio investments could raise the United States’ natural rate by roughly 100 basis points by 2050 (illustrative; model does not capture endogenous capital-flow responses).
  - Higher labor shares in advanced economies:
    - A return to labor shares prevailing in the mid-1970s would raise the natural rate by 6 to 19 basis points by 2050.
  - Energy transition:
    - A transition consistent with the 2015 Paris Agreement would push global natural rates lower in the medium term because higher energy prices reduce the marginal productivity of capital and investment demand.
    - For reasonable scenarios based on the October 2020 WEO, effects by 2050 are expected to be a decline of 50 basis points along a hump-shaped trajectory.
    - If large low-emission investment is financed through budget deficits, natural rates could temporarily climb by 30 basis points.
  - Deglobalization / trade and financial fragmentation:
    - Lower international trade would push down global output and desired investment; effects on natural rates vary by region.
    - Expected effects range between a 40 basis point decline and a 20 basis point increase, depending on the region.
    - Effects from trade fragmentation alone are expected to be smaller.

### Policy implications — monetary policy
- Once inflation returns to target:
  - Natural rates remain low in advanced economies or decline in emerging markets, limiting central banks’ ability to ease policy via lower nominal interest rates.
  - Central banks may rely on balance-sheet policy and forward guidance as used in the pre-pandemic decade.
  - If deflationary dynamics emerge, economies risk prolonged suboptimal equilibria with low growth and underemployment.
  - A larger stabilization role for fiscal policy and monetary-fiscal coordination may be necessary.
  - Debates about appropriate inflation targets may reopen given ELB constraints.

### Policy implications — fiscal policy and debt sustainability
- Key metric: the difference between the real interest rate (r) and the growth rate (g); if g > r, governments can sustain higher primary deficits.
- Framework:
  - A partial-equilibrium framework (based on Mian, Straub, and Sufi (2022)) takes natural rate and growth projections from the PP model as given.
  - Savers’ preference for government debt for liquidity and safety creates a “convenience yield” that discounts government borrowing costs.
  - As public debt increases, the convenience yield erodes and government borrowing costs rise; interest rates increase with the debt level.
  - The sensitivity (elasticity) of the convenience yield to debt is critical — higher sensitivity lowers the debt threshold for required primary surpluses.
- Required fiscal adjustment (changes in primary deficit, percentage points of GDP) — selected entries reported:
  - Near-Term Adjustment:
    - United States: –3.71
    - China: –7.63
  - Additional Consolidation Needed for Medium-Term Adjustment (three years):
    - United States: –0.17
    - China: –0.47
  - Additional Consolidation Needed for Medium-Term Adjustment (five years):
    - United States: –0.29
    - China: –0.87
- Interpretation and caveats:
  - For the United States, consolidation of about 3.7 percentage points of GDP is needed under the baseline; 3.9 percentage points under the higher-debt scenario; slightly greater under the higher-labor-share scenario.
  - For China, a deficit reduction of about 7.6 percent of GDP is required to stabilize the debt-to-GDP ratio over the long term, reflecting China’s primary deficit of about 7.5 percent of GDP in 2022.
  - Assumes fiscal adjustment can be undertaken in the near term or over the medium term; smaller initial primary deficits reduce the fiscal cost of waiting.
  - Robustness analysis: higher sensitivity of interest rates to debt reduces fiscal space, underscoring the importance of safety margins.

### Selected policy conclusions and recommendations
- Post-pandemic increases in real interest rates are likely temporary, mainly reflecting monetary tightening.
- Once inflation is under control, advanced-economy central banks are likely to ease policy and real rates should move back toward pre-pandemic levels unless persistent higher government debt, deficits, or financial fragmentation intervene.
- Large emerging markets are projected to see gradual convergence of their natural rates toward advanced-economy levels due to demographics and productivity trends.
- Structural policies that boost potential growth and reduce inequalities can counteract secular downward pressure on the natural rate.

### Box summaries — targeted scenario analyses
- Box 2.1 — Natural Rate and the Green Transition (G-Cubed simulations):
  - A comprehensive global net-zero-by-2050 policy package (budget-neutral via carbon taxes) was simulated.
  - Acting alone, carbon taxes depress investment and hence r*; public green investment and subsidies push r* up.
  - Net impact on r* depends on fiscal impulse: a deficit-financed front-loaded green push could raise r*; budget-neutral packages tend to depress r* along the transition path.
  - Partial international participation yields muted impacts versus full participation.
  - Over the long term, r* converges to its pre-climate-policy steady state as economies green.
- Box 2.2 — Geoeconomic Fragmentation (GIMF simulations):
  - A trade-fragmentation scenario raising nontariff barriers by 50 percent over 10 years reduces trade between blocs by about 19 percent and output by about 6 percent.
  - Trade restrictions act as negative productivity shocks via higher input prices; consumption import prices increase by about 5 percent to 25 percent depending on region.
  - Trade fragmentation effects on real rates:
    - China bloc: real rates fall by about 30 basis points (investment demand declines more than saving).
    - United States: offsetting saving and investment effects broadly balance.
    - Nonaligned bloc: real rates rise by about 10 basis points.
  - Financial-fragmentation scenario (permanent 100 basis point premium on one bloc’s assets held by the other):
    - After 10 years, China bloc domestic interest rate falls by 40 basis points; US bloc interest rate increases by 20 basis points; nonaligned countries’ rates fall by about 10 basis points.
- Box 2.3 — Spillovers to EMDEs:
  - Short-term (business cycle, < five years): domestic real rates dominate EMDE short-term real rate variation.
  - Horizons beyond a decade: US natural rate spillovers matter as much as domestic rates.
  - Cross-country heterogeneity:
    - East Asian and Latin American EMDEs show larger spillovers.
    - In China and India, about 30 percent of real-rate variation is explained by US natural rates after a decade.
    - African sample countries (Cameroon, Côte d’Ivoire, Uganda) show minor spillovers (< 10 percent).
  - Role of capital account openness:
    - A 1 percentage point increase in IIPGDP raises the importance of US natural-rate spillovers by 0.5 percentage point after a decade and 0.9 percentage point after two decades.
    - Example: Brazil (IIPGDP ~ 40 percent): US spillovers account for 20 percent of Brazilian real-rate forecast error variance after a decade and about 36 percent after two decades.

### Effective lower bound, monetary–fiscal interaction, and final implications
- The ELB and “low for long” dynamics are likely to resurface.
- Unconventional policies (central bank balance-sheet management and forward guidance) may become standard stabilization tools, potentially even for emerging markets.
- Debates about inflation targets may reemerge as countries weigh higher inflation’s social costs against ELB-induced stabilization limits.
- Permanently lower real rates increase fiscal space, enabling a larger fiscal stabilization role provided fiscal sustainability is maintained.
- Clarifying fiscal and monetary authorities’ responsibilities is crucial to preserve central-bank credibility.

*Source: CHAPTER 2, “THE NATURAL RATE OF INTEREST: DRIVERS AND IMPLICATIONS FOR POLICY,” WORLD ECONOMIC OUTLOOK: A ROCKY RECOVERY, International Monetary Fund | April 2023.*

### Introduction

### ch2 - Introduction

### Context and motivation
- Historical episodes illustrate that the same real interest rate can be either too low or too high depending on a changing reference level:
  - In 1979, the Federal Reserve hiked interest rates from about 10 percent at the start of the year to almost 14 percent by the year’s end, which in real terms—after taking account of inflation—amounted to a rate of interest of about 5 percent.
  - Inflation continued to rise, peaking at nearly 15 percent the following year, requiring even higher interest rates and a prolonged recession before the situation was brought under control.
  - Nearly three decades later, in response to the global financial crisis of 2008, central banks slashed interest rates to as close to zero as they thought possible in nominal and real terms; inflation remained stubbornly low for much of the next 10 years.
- Macroeconomic interpretation: a given real interest rate has different effects relative to a reference level called the natural rate of interest—the real rate that is neither stimulatory nor contractionary and is consistent with output at potential and stable inflation.
- The natural rate is typically driven by real phenomena such as technological progress, demographics, inequality, or preference shifts for safe and liquid assets.

### Key questions addressed
- How has the natural rate evolved in the past across different economies?
- What has driven this evolution?
- What is the outlook for these drivers and natural rates in the near and medium term?
- How will this outlook affect monetary and fiscal policies?

### Approach and methodology
- A two-pronged estimation strategy is adopted:
  - Start with a simple, data-driven model (Laubach and Williams 2003) that lets the data speak.
  - Move to a tighter theoretical structure (Platzer and Peruffo 2022) that imposes more restrictions and allows deeper analysis of underlying drivers.
- Comparing estimates from different models provides independent validation.
- Alternative scenarios for plausible future developments of main drivers are considered to assess robustness and provide a long-term anchor for monetary policy and debt sustainability analysis.

### Main findings
- Common trends have played an important role in driving real interest rates down:
  - The natural rate has declined over the past four decades in most advanced economies and some emerging markets.
  - Demographic transitions and productivity slowdowns are key synchronized drivers, although idiosyncratic factors explain cross-country differences.
- Global drivers have been important but had a limited net impact:
  - As global capital markets opened and fast-growing emerging market economies entered in the 1980s and 1990s, foreign factors increasingly shaped long-term interest rate trends.
  - High growth in emerging markets tended to drive up interest rates in advanced economies while producing a glut of savings in emerging markets; excess savings sought safe and liquid assets and flowed back to advanced economies, pushing natural rates down.
  - On balance, these forces broadly offset, producing a moderate impact on natural rates over the past half-century.
- Convergence prospects:
  - Country-specific natural rates are projected to converge in the next couple of decades under conservative assumptions on demographics, fiscal, and productivity developments, with large emerging market economies’ natural rates declining toward the low and steady levels expected in advanced economies.
- Policy constraints and implications:
  - As inflation returns to target, the effective lower bound (ELB) on nominal interest rates may become binding again.
  - Long-term forces suggest interest will eventually converge toward pre-pandemic levels in advanced economies; how close depends on scenarios involving persistently higher government debt and deficit or financial fragmentation.
  - Because nominal rates cannot fall far below zero, the ELB could limit central banks’ ability to respond to negative demand shocks, potentially reawakening debates about the appropriate level of target inflation at the ELB.
  - Some emerging market central banks may eventually need unconventional policy tools similar to those used by advanced economies.
- Fiscal implications:
  - Despite increased fiscal space from low natural rates, many countries will need fiscal consolidation to ensure long-term debt sustainability.
  - Delaying consolidation raises the scale of required adjustment; larger public debt tends to crowd out private investment and erode the appeal of safe and liquid government debt.

### Trends in real rates over the long term (stylized facts)
- US real rates across maturities:
  - Ex ante and ex post measures at 1-year, 2-year, 5-year, 10-year, and 20-year horizons share a common long-term trend: real rates have fallen steadily by about 5 percentage points over the last four decades across all maturities.
- Cross-country advanced economy patterns:
  - Three-month real rates for selected advanced economies (United States, Japan, Germany, United Kingdom, France) show a steady decline from highs in the 1980s and increasing prominence of a common international component and gradual convergence.
- Advanced vs emerging market economies:
  - Aggregated ex post real interest rates (sample: 34 advanced economies and 25 emerging market and developing economies, aggregated using market-exchange-rate-based GDP weights; maturities > one year; nominal rates deflated using consumer price inflation) display a shared trend at the start of the 2000s that decouples after 2011:
    - Real rates continued to decline in advanced economies.
    - Real rates stabilized at their 2005 level in emerging markets.
  - The divergence suggests frictions preventing stronger convergence despite broadly balanced current accounts.

### Measuring the natural rate
- Rationale:
  - The natural rate is an unobserved latent variable, so measurement requires theory; the chapter uses minimal theory with standard macro relationships between supply, demand, interest rates, and inflation.
- Single-country (HLW) estimates:
  - The Laubach-Williams/Holston-Laubach-Williams (HLW) model, rooted in a New Keynesian framework, is applied to individual countries.
  - The natural rate is defined as the real interest rate that will return output to potential and inflation to target once transitory shocks dissipate.
  - The framework decomposes changes in the natural rate into:
    - A component due to changes in long-term trend growth.
    - A component due to other factors, potentially domestic and foreign.
  - Limitations:
    - HLW is best suited to advanced economies with sufficiently long data consistent with New Keynesian dynamics.
    - Uncertainty around estimates is large because relationships between interest rates and the output gap, and output gap and inflation, are relatively weak.
- Empirical results (selected advanced economies):
  - Estimates for six advanced economies over two five-year periods (end of the 1970s and late 2010s) confirm a decline in the natural rate across advanced economies over the past 40 years.
  - The magnitude of decline is broadly similar across countries, at a little over 2 percentage points in most countries.
  - This decline in the natural rate is smaller than the roughly 5 percentage point decline in real interest rates over the same period, reflecting changes in monetary policy stance (notably tighter policy in the early 1980s).
  - Confidence intervals are wide; for the United States the 90 percent confidence interval in the second half of the 2010s ranges from zero to about 3 percent.
  - The trend growth component of the natural rate is better estimated (narrower confidence intervals) because output data are directly informative about trend growth.
  - Except for Japan, the drop in the natural rate exceeds what is implied solely by changes in trend growth, implying additional forces beyond domestic growth reductions.

*Source: ch2 - Introduction (PDF chapter).*

### 1. Canada

### 2. Canada

### Estimated natural rate and cross-country patterns
- Canada is one of the selected advanced economies for which Kalman filter (HLW) estimates of the natural rate are reported (Figure 2.3).
- The chapter notes that estimated natural rates are more similar across countries now than 40 years ago, consistent with increased capital market integration among advanced economies.
- The HLW closed-economy approach remains a useful benchmark but cannot capture international spillovers explicitly; this motivates multicountry extensions.

### The natural rate during the COVID-19 pandemic
- Different vintages of estimates (contemporaneous versus full-sample up to 2022:Q3) show substantial differences early in the pandemic:
  - Contemporaneous estimates often presented a much tighter view of monetary policy because the model interpreted large supply shocks as having a large permanent component, generating an exceptionally low natural rate.
  - Subsequent data revised away much of the sharp early-pandemic decline in the natural rate, implying that policymakers who looked through the immediate crisis and applied judgment delivered moderately stimulatory policy.
- Later in the pandemic, policy became looser largely because inflation eroded real policy rates; contemporaneous and full-sample estimates were generally much closer by that stage.
- The HLW model suggests that policy was loose for a long time in some countries (reference: October 2022 Global Financial Stability Report).
- The measures and figures for Canada appear in the same set of panels comparing realized real rates and natural rates across advanced economies (Figure 2.4). Note: the ranges in figures show 90 percent confidence intervals. Parameters are estimated on pre-COVID data.

### Multicountry estimates and international spillovers
- A two-region multicountry framework (Wynne and Zhang 2018 style) allows the natural rate to be affected by both domestic and foreign growth, capturing two-way international spillovers.
- In the United States vs. rest-of-world two-region exercise:
  - The natural rate in the United States has declined by about 2 percentage points in the past 50 years.
  - The estimated natural rate in the rest of the world has been more stable since the mid-1970s.
  - Two offsetting international channels are highlighted:
    - Overseas growth (red) has helped support the US natural rate.
    - “Other factors” (yellow), increasingly negative for the US, reflect higher foreign demand for safe and liquid US assets which depressed returns.
- The chapter cautions about interpretation: the multicountry estimation is not disciplined by current account data and confidence bands are large, making inference imprecise.

### Drivers of the natural rate — taxonomy and mechanisms
- The chapter separates drivers into macroeconomic and financial forces and notes that importance varies by frequency (macroeconomic forces for long-term trends; financial forces for short- to medium-term).
- Macroeconomic drivers listed:
  - Productivity growth: higher productivity growth raises the natural rate via higher marginal product of capital.
  - Demographics: fertility and mortality changes affect growth, dependency ratios, and aggregate desired saving (Online Annex 2.3 referenced).
  - Fiscal policy: increased government borrowing can raise interest rates depending on private investment displacement.
  - Market power and labor share: ambiguous net effect; depends on distributional channels and cohort impacts.
  - Other reasons: taxation effects on consumption/saving profiles, rising inequality increasing aggregate saving, and interactions among channels.
- Financial drivers listed:
  - International capital flows and scarcity of safe assets: high-growth emerging markets can raise advanced-economy natural rates via capital outflows, while a shortage of safe liquid assets (notably US government bonds) can depress returns.
  - Risk aversion and leverage cycles: convenience yields on safe assets rise in stress, strengthening safe-haven demand (especially for US Treasurys).

### A new structural (PP) framework and its implications
- The chapter employs a macroeconomic model (PP) based on Platzer and Peruffo (2022) that unifies many mechanisms in a single framework to quantify contributions to the natural rate, avoiding double-counting from separate calibrated models.
- PP is a “real” model abstracting from nominal and financial frictions and from uncertainty; it still allows foreign developments to affect domestic rates via net international capital flows.
- PP calibration covers eight major global economies: the United States, Japan, Germany, the United Kingdom, France, China, India, and Brazil — collectively covering some 70 percent of global GDP.
- Model inputs include: demographic developments, age-earning profile, share of income to the richest 10 percent, productivity trends, retirement age, average pension replacement rates, labor share, government debt, and public expenditure.

### Model findings relevant to the recent decline in natural rates
- Across the eight-country PP exercise:
  - No single factor dominates the past 40-year decline; a set of common forces explains part of international comovement.
  - Population aging contributed negatively to the change in the natural rate in all eight countries; the effect was particularly large in China, Japan, and Germany.
  - Growth in total factor productivity (TFP) declined in all advanced economies and at times explained far more than the final decline in the natural rate.
  - Fiscal policy acted as an important offset in many economies:
    - In Japan, public debt increased by more than 200 percent of GDP, lifting the natural rate by more than the negative contributions from TFP growth or demographics.
    - In Brazil, a large increase in public consumption financed by taxation explains the positive fiscal contribution; increases in public debt also play a role.
  - Net international capital flows constitute a significant but smaller contribution, with the largest net negative effect found in the United States — consistent with emerging-market demand for safe assets more than offsetting capital outflows to attractive foreign investments.
  - In Japan, capital outflows dominate, lifting its natural rate as excess domestic savings are invested in faster-growing economies abroad.
- The PP and HLW frameworks produce strikingly similar overall declines in the natural rate (Figure 2.6), providing cross-method reassurance.

*Source: IMF staff summary of chapter content in ch2 - 1. Canada from the provided PDF content.*

### 1. France2. Germany

### ch2 - 1. France2. Germany

### Drivers of Natural Rate Changes (1975–79 to 2015–19)
- Decomposition (Figure 2.7) highlights contributions to changes in the natural rate from:
  - Demographics
  - TFP growth (total factor productivity)
  - Fiscal (public debt)
  - Capital flows
  - Other factors
- Source data: Platzer and Peruffo (2022); and IMF staff calculations.
- Note: TFP = total factor productivity.

### Outlook for the Natural Rate — Baseline
- Baseline assumptions:
  - Predicted demographic trends follow United Nations population projections.
  - Public debt follows World Economic Outlook (WEO) projections until 2028 and remains constant thereafter.
  - All other drivers are fixed at their 2015–19 levels.
  - In emerging markets, TFP growth is assumed to converge to the advanced economies’ average over the long term.
- Main baseline projections:
  - Natural interest rates are likely to stay close to pre-pandemic levels in advanced economies.
  - In emerging markets, a significant decline in natural rates is projected because of slowing productivity growth and an accelerating demographic transition.
  - Example projection for China: a steady decline in the natural rate by about 1.5 percentage points within the next 30 years, bringing it to about zero in 2050.
- Assumes some degree of segmentation remains between capital markets of advanced economies and emerging markets and that the balance of capital inflows and outflows stays as in 2019.

### Alternative Scenarios (deviations from baseline)
- Overall expected deviations span about 120 basis points centered on the baseline; larger effects possible if scenarios combine.
- Identified scenarios and modeled impacts:
  - Higher government debt:
    - Allowing public debt to increase by 25 percent of GDP above the baseline by 2050 would increase demand for private savings and lift the natural rate.
    - Modeled impact should not exceed 5 to 10 basis points for most countries.
  - Erosion of the convenience yield (advanced economies):
    - If the premium investors pay for safe, liquid government debt erodes to pre-2000 average levels, natural rates in advanced economies (and lower corporate bond yields) would rise by about 70 basis points.
    - The model does not capture endogenous capital flow responses; a full reversal of large foreign portfolio investments could raise the United States’ natural rate by roughly 100 basis points by 2050 (illustrative).
  - Higher labor shares in advanced economies:
    - A return to labor shares prevailing in the mid-1970s would raise the natural rate by 6 to 19 basis points by 2050.
  - Energy transition:
    - Transition consistent with the 2015 Paris Agreement would push global natural rates lower in the medium term because higher energy prices reduce the marginal productivity of capital and investment demand.
    - For reasonable scenarios based on the October 2020 WEO, effects by 2050 are expected to be a decline of 50 basis points along a hump-shaped trajectory.
    - If large low-emission investment is financed through budget deficits, natural rates could temporarily climb by 30 basis points.
  - Deglobalization / trade and financial fragmentation:
    - Lower international trade would push down global output and desired investment; effects on natural rates vary by region.
    - Expected effects range between a 40 basis point decline and a 20 basis point increase, depending on the region.
    - Effects from trade fragmentation alone are expected to be smaller.

### Policy Implications — Monetary Policy
- Once inflation returns to target, long-term forces suggest:
  - Natural rates remain low in advanced economies or decline in emerging markets, limiting the ability of central banks to ease policy by lowering nominal interest rates.
  - Central banks may rely on balance sheet policy and forward guidance as in the pre-pandemic decade.
  - If deflationary dynamics take hold, economies risk prolonged suboptimal equilibrium with low growth and underemployment.
  - A larger stabilization role for fiscal policy may be needed, and monetary-fiscal coordination could be necessary.
  - Reopening debate on appropriate inflation targets may be warranted.

### Policy Implications — Fiscal Policy and Debt Sustainability
- Key debt sustainability factor: the difference between the real rate of interest (r) and the growth rate (g).
  - If g > r, governments can sustain higher primary deficits without compromising debt sustainability.
- Framework used:
  - Partial equilibrium framework (based on Mian, Straub, and Sufi (2022)) takes natural rate and growth projections from the PP model as given.
  - Assumes savers prefer government debt for liquidity and safety; this preference creates a “convenience yield” that discounts government borrowing costs.
  - As public debt increases, the convenience yield erodes and government borrowing costs rise; interest rates increase with the debt level.
  - Sensitivity (elasticity) of the convenience yield to debt is critical — higher sensitivity lowers the debt threshold for required primary surpluses.
- Required fiscal adjustment (difference from long-term debt-stabilization level) — Table 2.1 (changes in primary deficit, percentage points of GDP):
  - Near-Term Adjustment:
    - United States: –3.71
    - China: –7.63
  - Additional Consolidation Needed for Medium-Term Adjustment (three years):
    - United States: –0.17
    - China: –0.47
  - Additional Consolidation Needed for Medium-Term Adjustment (five years):
    - United States: –0.29
    - China: –0.87
- Interpretation and caveats:
  - For the United States, consolidation of about 3.7 percentage points of GDP is needed under the baseline; 3.9 percentage points under the higher-debt scenario; slightly greater under the higher-labor-share scenario.
  - For China, a deficit reduction of about 7.6 percent of GDP is required to stabilize the debt-to-GDP ratio over the long term, reflecting China’s primary deficit of about 7.5 percent of GDP in 2022.
  - Assumes fiscal adjustment can be undertaken in the near term or over the medium term; smaller initial primary deficits reduce the fiscal cost of waiting.
  - Robustness analysis shows higher sensitivity of interest rates to debt reduces fiscal space, underscoring the importance of safety margins.

### Conclusion — Key Takeaways
- Recent post-pandemic increases in real interest rates are likely temporary and primarily reflect monetary tightening.
- Once inflation is under control, advanced economies’ central banks are likely to ease policy and real interest rates should move back toward pre-pandemic levels, barring persistent higher government debt, deficits, or financial fragmentation.
- Large emerging markets are projected to see gradual convergence of their natural rates toward advanced economies’ levels due to demographic and productivity trends.
- Structural policies that boost potential growth and diminish inequalities can counteract downward secular forces on the natural rate.

*Source: IMF staff calculations.*

### CHAPTER 2

### CHAPTER 2

### Effective lower bound, monetary–fiscal interaction, and policy implications
- The “effective lower bound” constraint on interest rates and “low (interest rates) for long” are likely to resurface.
- Unconventional policies through active management of central bank balance sheets and forward guidance may become standard stabilization tools, even in emerging markets.
- Debates about the appropriate level of inflation target may reemerge as countries weigh the social cost of higher inflation against the constraint of ineffective stabilization due to the effective lower bound.
- Permanently lower real interest rates increase fiscal space—all else equal—and allow fiscal authorities to take a more active role in stabilizing the economy, provided fiscal sustainability is ensured (Chapter 2 of the April 2020 WEO).
- It is crucial to clarify the scope and responsibilities of fiscal and monetary authorities to avoid long-term damage to the credibility of central banks.

*Box authors referenced in chapter text: Augustus Panton and Christoph Ungerer.*

---

### Box 2.1 — The Natural Rate of Interest and the Green Transition
- Scenario design and modelling:
  - A comprehensive and global policy package intended to achieve net zero emissions by 2050 is used as a benchmark (simulated with the G-Cubed model).
  - Carbon taxes are imposed globally, starting at between $6 and $20 a metric ton of CO2 (depending on the country), reaching $40 a ton in 2030 and between $40 and $150 a ton in 2050.
  - The package is fully financed by the carbon tax revenues—25 percent recycled toward social transfers, up to 70 percent for green public infrastructure investment, and the rest as subsidies to renewable energy sectors—making the policy budget-neutral.
  - The scenario assumes budget neutrality (no debt financing) and does not assume direct productivity gains from green public investment in the simulations.
- Key simulation findings:
  - Acting alone, carbon taxes depress overall investment and hence r* because the carbon tax increases the overall cost of energy, a complement in production to physical capital; frictions cause the decline in carbon-intensive activities to exceed investment in renewable sources.
  - Public investment in green infrastructure and subsidies to renewable energy positively affect investment, pushing up r*.
  - Climate mitigation helps avoid climate-change-related damages, boosting productivity growth relative to a business-as-usual baseline and raising r*.
  - The net impact on r* depends on the associated overall fiscal impulse:
    - A deficit-financed, front-loaded green investment push could have a positive impact on r* because it increases demand for private savings.
    - The budget-neutral policy package tends to depress r* along the transition path.
  - International participation matters:
    - Partial participation (only some countries participating) leads to a significantly more muted impact on r* compared with full global participation.
  - Over the long term, r* would converge to its pre-climate-policy steady state as economies become greener and climate policy applies to a shrinking share of economic activity.
- Modelling notes:
  - Simulations computed with the G-Cubed model, an open-economy, multicountry macroclimate model.
  - The scenario differs from Chapter 3 of the October 2020 WEO by assuming budget-neutral design and not assuming productivity gains from green public investment.
- Box authors: Augustus Panton and Christoph Ungerer.

---

### Box 2.2 — Geoeconomic Fragmentation and the Natural Interest Rate
- Scenario setup:
  - Uses the IMF’s Global Integrated Monetary and Fiscal (GIMF) Model to analyze two scenarios of trade and financial fragmentation between the “US bloc” (United States, European Union, other advanced economies) and the “China bloc” (China, emerging Southeast Asia, remaining countries group).
  - The trade-fragmentation scenario is a gradual increase in nontariff barriers between the US bloc and the China bloc for all types of traded goods (intermediate, investment, and consumption) of 50 percent over 10 years.
  - The fragmentation scenario reduces trade between the two regions by about 19 percent and output by about 6 percent.
  - The modelling calibrates value chains and treats intermediate inputs and capital as complements in production.
- Trade-fragmentation channels and effects:
  - Trade restrictions increase import prices for all goods and act as negative productivity shocks by raising prices of crucial production inputs.
  - Consumption price impacts: the price of imported consumption goods increases by about 5 percent to 25 percent depending on the region.
  - Effects on saving and investment:
    - Higher import prices and reduced output tend to reduce saving and push up the natural rate.
    - Higher input prices lower profitability and depress investment demand.
    - Trade restrictions increase the relative price of investment goods (higher import share), which, all else equal, increases demand for loanable funds.
  - Net trade outcome:
    - Reduction in trade between blocs is partially offset by larger trade within blocs and with the nonaligned, but the net effect is a shortening of the global value chain and less global trade (–19 percent).
  - Regional investment impacts:
    - Real investment in the China bloc declines the most due to reshoring.
- Impact on real interest rates (trade fragmentation):
  - Real interest rates are expected to fall by about 30 basis points in the China bloc as investment demand declines more than saving does.
  - In the United States, the positive impact of lower saving on the natural rate and the negative impact of declining investment broadly balance out.
  - In the nonaligned bloc, investment demand declines by less than desired saving, which raises the real interest rate by about 10 basis points.
- Financial-fragmentation scenario and impacts:
  - Scenario modeled as a permanent 100 basis point premium on one bloc’s assets held by the other bloc’s economic agents (reducing China bloc exposure to US bloc Treasury bonds).
  - After 10 years:
    - The China bloc disposes of net foreign assets, which pushes down their domestic interest rate by 40 basis points.
    - In the US bloc, the interest rate increases by 20 basis points and the net foreign asset position improves by 10 percent of GDP.
    - The nonaligned countries experience slight net capital inflows from the China bloc, reducing their interest rates by about 10 basis points.
- Box authors: Benjamin Carton and Dirk Muir.

---

### Box 2.3 — Spillovers to Emerging Market and Developing Economies (EMDEs)
- Research question and focus:
  - Do movements in the natural rate of interest in advanced economies impact real interest rates in EMDEs, at what horizon, how strong are associations, and what determines their strength?
  - Focuses on short-term real rates relevant to monetary policy stance (quarterly short-term deposit rates adjusted for ex post realized inflation; data cover Q1 2020 to Q4 2022).
  - Sample of EMDEs includes Algeria, Bangladesh, Bolivia, Brazil, Cambodia, Cameroon, Chile, China, Colombia, Costa Rica, Côte d’Ivoire, Hungary, India, Indonesia, Jordan, Malaysia, Mexico, Nigeria, Peru, South Africa, Thailand, Türkiye, and Uganda.
  - Method: contribution of the US natural rate to individual EMDE forecast error variance decomposition using bivariate vector autoregression models.
- Key empirical findings:
  - At business cycle horizons of less than five years, domestic real rates dominate EMDE short-term real rate variation.
  - At horizons beyond a decade, spillover from the US natural rate matters just as much as domestic rates.
  - Cross-country heterogeneity:
    - The contribution from the US natural rates tends to be larger for East Asian and Latin American countries.
    - In large EMDEs such as China and India, about 30 percent of real rate variation is explained by US natural rates after a decade.
    - After two decades, spillovers are somewhat stronger in China than in India.
    - African countries in the sample (Cameroon, Côte d’Ivoire, Uganda) show minor spillovers, with less than a 10 percent contribution from US natural rate spillovers.
- Role of capital account openness:
  - De facto capital openness measured as the sum of foreign assets and liabilities as a percent of GDP (IIPGDP).
  - A 1 percentage point increase in IIPGDP raises the importance of the US natural rate in explaining EMDE real interest rate movements by half a percentage point after a decade and by 0.9 percentage point after two decades.
  - Example: For Brazil, with an IIPGDP of about 40 percent, 20 percent of the forecast error variance decomposition of Brazilian real interest rates is attributable to US spillovers after a decade, and about 36 percent after two decades.
  - The effect of capital account openness on the strength of US spillovers becomes significant only gradually after about a decade.
- Data and methodological notes:
  - To avoid spurious regression, selection required cointegration with the US rate series; Phillips-Perron test used for stationarity of residuals allowing up to four lags.
  - Forecast error variance decomposition contributions weighted by GDP weights adjusted for purchasing power.
- Box authors: Christoffer Koch and Diaa Noureldin.

*Source: CHAPTER 2, “THE NATURAL RATE OF INTEREST: DRIVERS AND IMPLICATIONS FOR POLICY,” WORLD ECONOMIC OUTLOOK: A ROCKY RECOVERY, International Monetary Fund | April 2023.*

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*International Monetary Fund | April 2023*

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_Source: https://www.imf.org/-/media/files/publications/weo/2023/april/english/ch2.pdf_