What next for r*? A capital market equilibrium perspective on the natural rate of interest

The natural rate of interest (r ∗ ) is a central benchmark for monetary and fiscal policy, shaping decisions by firms and households across the economy. In advanced economies, r ∗ declined steadily for half a century, but the recent sharp increases in market-based real rates have raised the prospect of a turnaround. This paper revisits the long-run decline in real rates through a structural model in which r ∗ equilibrates the supply and demand in the capital market. I show that advanced economies have undergone profound shifts in both capital demand but – especially – capital supply, driving a fall in r ∗ of about 5 percentage points and nearly doubling the wealth-to-GDP ratio since 1970, despite weak investment and low saving. To trace the dynamics, I construct a limited-foresight transition in which agents notice and understand the shocks hitting the economy only as they arrive. I argue this is a more plausible alternative to the usual perfect foresight assumption. The model’s business-as-usual scenario computed this way implies r ∗ of around 0%-1.2% today, and points to a small gentle decline over the years to come. But r ∗ could instead rise, due to new forces such as AI, deglobalization, or a persistent fall in the safety premium following the recent inflation episode. The model is capable of generating a sharp turnaround in the path for the natural rate, but for r ∗ to return to pre-2008 levels, several upside risks to r ∗ likely need to crystallize all at once.