Question 1: What is the neutral interest rate and why is it relevant?

An increasing number of countries have been strengthening their monetary policy frameworks to contain inflation and anchor inflation expectations in recent decades. Some of them moved to inflation targeting, using a policy interest rate as the main instrument. When calibrating the monetary policy stance, policymakers need to know how the current policy interest rate compares to a benchmark or neutral rate. The concept of the neutral interest rate was originally suggested by Wicksell (1898), who defined the natural real interest rate as the long-run equilibrium rate that equates saving and investment (thus, being non-inflationary, or neutral); and which in the absence of frictions would equal the marginal product of capital. However, since policymakers are mostly interested for the short to medium term, and given frictions and other market imperfections in the economy, in applied economics we typically focus our attention on the short-run (or “operationally”) neutral real policy interest rate. That is the real policy rate consistent with a closed output gap and stable inflation—which might differ from the long-run natural interest rate because of market frictions or other temporary conditions. In Magud and Tsounta (2012), we analyze various issues about the neutral interest rate considering the recent experience of 10 Latin American countries. For our purposes here, we refer to the neutral real policy interest rate as the neutral real interest rate (NRIR).

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

The NRIR is not an observable variable, so there is no unique way to estimate it. Moreover, it can change over time given changes in macroeconomic fundamentals and global interest rates. For these reasons, the task of estimating the NRIR has become particularly complex in the current conjecture: there have been significant structural changes in domestic capital markets in numerous countries, improved macroeconomic fundamentals in many emerging economies, as well as sharply lower global interest rates.

As there is no single best estimation method, and recognizing differences in country characteristics and data availability, recent papers usually utilize a variety of different methodologies to compute an NRIR range for a country rather than a specific point estimate. (See for example Adolfson and others (2011) for Sweden, Duarte (2010) for Brazil, Gonzalez and others (2012) for Colombia, Laubach, and Williams (2003) for the United States, Magud and Tsounta (2012) for a large group of Latin American countries, Ogunc and Batmaz (2011) for Turkey, and Pereda (2010) for Peru). These studies largely utilize static methods (such as those based on the interest parity condition or fitting a consumption-smoothing model) as well as dynamic methods (which, based on statistical filters, estimate neutral rates for systems of equations that fit a Phillips curve—with or without an investment-savings equation—or considering the term structure of the yield curve of a country).

Question 3: How do policymakers use the neutral interest rate in their monetary policy decisions?

Central bankers are interested in the interest rate gap—i.e., the difference between the actual real policy rate (i.e., central bank’s benchmark/policy rate deflated by expected inflation) and the estimated NRIR. When the real policy rate is lower than the estimated neutral real interest rate, then monetary policy is considered expansionary, and vice-versa. This helps policymakers to make decisions on whether changes on the policy rates are warranted, conditional on the cyclical state of the economy.

Question 4: What do recent estimates of neutral interest rates suggest for Latin America?

We employ a battery of commonly used methodologies and estimate ranges of neutral interest rates for 10 inflation targeting countries in Latin America for the period 1990–2012. Despite the differences in methodologies, each country’s neutral interest rate point estimates are usually clustered within a 200 basis points band—in particular for the more developed Latin American economies. As expected, we find lower levels of the neutral interest rate in more economically and financially developed economies; Brazil is an exception, however. We also document a downward trend in the neutral interest rate for all the countries in our sample during recent years. Stronger domestic economic fundamentals (lower exchange rate risk and inflation risk premiums, as well as fiscal consolidation) and easing global financial conditions are possible explanations for this trend. In all cases, we observe that near-record low global interest rates following the 2008 global financial crisis affected neutral interest rates. Based on these estimates, we find that for most countries, the monetary stance is currently appropriate—close to neutral and in line with closing output gaps.

Question 5: Has monetary policy been effective in Latin America?

Our analysis can provide some preliminary insights on the effectiveness of monetary policy. In particular, does it affect the output gap, future economic growth, and inflation rates? More rigorous causality tests would be needed for more concrete and definite answers. However, visual inspection in financially integrated economies reveals that interest rate gaps and output gaps are positively correlated. This observed correlation would suggest that central banks have been responding counter-cyclically to business cycle fluctuations. In addition, monetary policy appears to have been effective in fine-tuning the business cycle, as periods of accommodative monetary policy (negative interest rate gaps) are often followed by shrinking (negative) output gaps—and vice versa.

For most of the countries studied, we also find that the interest rate gap is negatively correlated with future GDP growth. Periods of expansionary monetary policy are followed by above-trend growth (typically within nine months). However, the impact on GDP dissipates as the interest rate approaches its neutral level. These findings are in line with the work of Neiss and Nelson (2003).

When comparing interest rate gaps with deviations of inflation from the target rate (the inflation gap), as in Woodford (2003), we observe that central banks typically undertake restrictive monetary policies if the rate of inflation exceeds the target (and vice-versa). Uruguay and Mexico are exceptions, probably owing to the persistently above target inflation rates that they have experienced for the whole sample period.

Question 6: In recent years, did Latin American countries deploy unconventional monetary policies to affect their financial conditions?

We document that in recent years Peru and Brazil have used less conventional measures to affect financial conditions. These measures, or macroprudential policies, include, among others, changing reserve requirements and imposing limits on currency mismatches or on loan-to-value ratios. Following significant monetary easing amid the global financial crisis, both Brazil and Peru started implementing restrictive macroprudential policies in the second half of 2009 to contain domestic credit, without altering their policy rate.

Question 7: Is the neutral interest rate relevant given an increasing use of unconventional monetary measures?

The simple answer seems to be yes! The experience of Brazil and Peru suggest that macroprudential policies appear to affect the estimated neutral real interest rate, possibly through their effect on credit conditions. Implicitly, it seems that the NRIR is affected by the workings of the credit channel. Specifically, these economies in recent years had experienced a surge in their (carry-trade driven) capital inflows, resulting in increasing domestic currency deposits and, thus, credit growth. Macroprudential polices seem to have lowered the NRIR by mitigating the expansionary effect of the credit channel on GDP by containing the demand for loanable funds. Thus, macroprudential policies could supplement standard macroeconomic policies by directly affecting the credit channel; and they could thereby safeguard financial stability without the unintended consequences of higher capital inflows that a rise in the policy rate might entail. That said, more research is needed to better understand and quantify the impact of specific macroprudential policies on credit growth, the output gap, and thus the neutral real interest rate, as well as to determine whether this impact is of a temporary or permanent nature.