Definition of neutral rate of interest
The neutral (or natural) rate of interest is the rate at which real GDP is growing at its trend rate, and inflation is stable. It is attributed to Swedish economist Knut Wicksell, and forms an important part of the Austrian theory of the business cycle.
The neutral rate provides an important benchmark for policymakers to compare with the market rate. When interest rates are neutral the economy is on a sustainable path, and it is deviations from neutrality that cause booms and busts. For example if the market rate is pushed artificially below the neutral rate (for example through monetary expansion) then people receive a false signal to invest in more interest-sensitive projects. It is by separating interest rates from their market clearing level that central banks have the potential to create monetary instability.
Because the neutral rate is a hypothetical construct we cannot observe it. Economists tend to believe that it is around 5 per cent, although Morgan Stanley estimates that it is currently under 3 per cent.