The Yield Curve’s Search for the Natural Rate of Interest

Abstract

Two novel models specify interest rates from factors other than time to demonstrate bond market expectations of riskless rates converge to the natural rate of interest.

The first yield curve model is based upon risk rather than time. The riskless rate is the incremental yield for an infinitesimal amount of risk and is computed directly from bond yields. Resulting expected riskless rates are comparable to survey measures of expected short-term rates. Conversely, expected riskless rates for specific periods produce expected bond yields for those periods that also are comparable to survey expectations measures. The model produces a typical concave yield curve shape.

The second model aligns with Wicksell’s original conception of a natural rate of interest as determined by productivity of real capital rather than time. The natural rate is the capital factor share of incremental growth from capital investment. The savings/consumption function is determined by equivalence between incremental capital product and forgone consumption, replacing the problematic IS equation. This proxy provides a real rate of interest consistent with short-term yields in the U.S. and other advanced economies, especially when adjusted for central bank intervention. The measure is more stable and easier to estimate than other natural rate measures.

This natural rate of interest proxy provides better forecasts of riskless rates over multi-year horizons than do expectations measures. Future yield curves are expected to be flatter and future real rates lower than historical averages.

Keywords: Yield Curve, Term Structure, Expectations, Natural Rate, Interest Rate Forecasts

JEL Classification: E43, E44, E52, G12