Q&A: Seven Questions on the Neutral Interest Rate in Latin America and Beyond

• Author: Nicolas E. Magud - Evridiki Tsounta
• Pages: 6-8

IMF Research Bulletin

6

Deciding whether to

cut, raise, or keep on

hold the policy rate is

an important issue in

the minds of central

bankers and market

participants alike.

The neutral interest rate is a benchmark interest rate often

used to guide this policy decision. This Q&A article provides

brief answers to seven questions about the neutral

interest rate through the recent experience of 10 Latin

American countries.

Question 1: What is the neutral interest rate and why is

it relevant?

An increasing number of countr ies have been strengthen-

ing their monetar y policy frameworks to contain inat ion

and anchor ination expe ctations in recent decades. Some

of them moved to ination target ing, using a policy interest

rate as the main in strument. When calibrating t he monetary

policy stance, polic ymakers need to know how the current

policy interest rate compares to a benchma rk or neutral rate.

e concept of the neutral interest rate was original ly sug-

gested by Wicksell (1898), who dened the natural real inter-

est rate as the long-run equil ibrium rate that equates saving

and investment (thus, being non-inationar y, or neutral);

and which in the absence of f rictions would equal the mar-

ginal product of capital . However, since policymakers are

mostly interested for the short to mediu m term, and given

frictions and other ma rket imperfections in the economy,

in applied economics we typica lly focus our attention on

the short-run (or “operationally”) neutral real policy inter-

est rate. at is the real pol icy rate consistent with a closed

output gap and stable ination—which mig ht dier from

the long-run natural i nterest rate because of market fric-

tions or other temporary conditions . In Magud and Tsounta

(2012), we analyze var ious issues about the neutral interest

rate considering the recent exper ience of 10 Latin American

countries. For our purpose s here, we refer to the neutral real

policy interest rate as the neut ral real interest rate (NRIR).

Question 2: How can we calculate the neutral interest rate?

e NRIR is not an obser vable variable, so there is no

unique way to estimate it. Moreover, it can change over

time given changes in ma croeconomic fundamentals and

global interest rates. For thes e reasons, the task of estimating

the NRIR has be come particularly complex in the cur rent

conjecture: there have been signi cant structural cha nges in

domestic capital markets i n numerous countries, improved

macroeconomic fundamenta ls in many emerging econo-

mies, as well as shar ply lower global interest rates.

As there is no single best est imation method, and rec-

ognizing di erences in country characterist ics and data

availability, recent papers usua lly utilize a variet y of dier-

ent methodologies to compute an NRIR ra nge for a country

rather than a speci c point estimate. (See for example Adolf-

son and others (2011) for Sweden, Duarte (2010) for Brazil,

Gonzalez and ot hers (2012) for Colombia, Laubach, and

Williams (2003) for the United States, Mag ud and Tsounta

(2012) for a large group of Latin Americ an countries, Ogunc

and Batmaz (2011) for Turkey, and Pereda (2010) for Peru).

ese studies largely uti lize static methods (such as those

based on the interest parit y condition or tting a consump-

tion-smoothing model) as well as dy namic methods (which,

based on statistica l lters, estimate neutral rates for system s

of equations that t a Phill ips curve—with or without an

investment-savings equation—or considering t he term

structure of t he yield curve of a country).

Question 3: How do policymakers use the neutral interest

rate in their monetary policy decisions?

Central bank ers are interested in the interest rate gap—

i.e., the dierence between t he actual real policy rate (i.e.,

central bank ’s benchmark/policy rate deated by expected

ination) and the esti mated NRIR. When the real polic y

rate is lower than the esti mated neutral real interest rate,

then monetary polic y is considered expansionary, and

vice-versa. is helps policy makers to make decisions on

whether changes on the polic y rates are warranted, condi-

tional on the cyclica l state of the economy.

Seven Questions on the Neutral Interest Rate

in Latin America and Beyond

Nicolas E. Magud and Evridiki Tsounta

Q&A