Abstract: The neutral interest rate is the risk-free real interest rate when the economy is at full employment, and inflation is at its target level. Like potential output, the neutral interest rate is an unobservable rate, yet it is an important concept and indicator for financial markets, interest rate analysis, and monetary policy. Although the neutral interest rate cannot be directly measured, real interest rates can be observed. Unlike the continuous decline in real interest rates in developed economies, China’s real interest rates have risen significantly since 2011. Estimating China’s neutral interest rate and comparing the trends of real interest rates and the neutral interest rate offers valuable insights into understanding the current economic environment and macroeconomic policy.
This paper examines the trend of China’s neutral interest rate through three methods: the return on assets of listed companies, the capital-output ratio, and a cross-country panel regression. The results show that, after 2010, the continuous decline in the return on assets of listed companies and the continuous rise in ICOR (Incremental Capital-Output Ratio) suggest a decline in the marginal output of capital, reflecting downward pressure on the neutral interest rate. Cross-country panel analysis, which incorporates other countries' interest rate experiences, when applied to China's fundamentals, policy, and cyclical data, indicates a trend of decline in China’s neutral interest rate. Population structure changes and savings rate fluctuations are identified as the primary drivers of the downward trend. Furthermore, an analysis of the interest rate gap reveals that, in most years since 2010, real interest rates have been significantly higher than the neutral interest rate, indicating a more robust monetary policy stance.
By analyzing the trends of real and neutral interest rates, we can derive the following insights:
First, economic growth rate is neither the sole determinant nor necessarily the most crucial factor in setting interest rate levels. Demographic shifts and changes in savings rates are equally significant factors influencing the neutral interest rate.
Second, when evaluating interest rate levels, it's imperative to choose an appropriate frame of reference. If we use historical rates and international interest rates as benchmarks, China's current interest rates are indeed relatively low. However, if we use the neutral interest rate as our comparative baseline, the current real interest rate is notably higher than the neutral rate.
Third, in an environment where the neutral interest rate is low, the significance of nominal variables becomes more pronounced. Swiftly restoring robust nominal growth should be the primary objective of current macroeconomic policy. We reiterate our recommendation that macroeconomic policy temporarily shift towards targeting nominal GDP growth rates.
