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
from: Financial Times – Lexicon
In reality, the above definition is not universally accepted and a lot of economists says that, although a natural interest rate should exist, it’s actually unkown. The natural rate of interest differs from the real rate of interest, whose long term value shows the tendency towards the same value, albeit in the short term can be higher or sometimes even negative, while the natural rate should be positive by definition. According to the definitions given by Lundwall and Westermark, the real rate of interest is “the nominal interest rate over the loan’s maturity minus
expected inflation over the same period” while the natural rate is “the real interest rate that would prevail if resource utilisation in the economy was normal today and was expected to remain normal in the future”.