The trend real rate as we have seen is determined by slow-moving structural factors that determine the underlying balance of the supply of savings and the demand for investment. But the interest rate necessary to offset the impact of unexpected outcomes – shocks – hitting the economy can vary significantly around the trend real rate over an economic cycle. Over the economic cycle, the natural rate will lie below the trend real rate when the economy needs stimulus to offset a negative demand shock and above it when demand needs to be reined in. The actual monetary policy rate, Bank Rate in the UK, may well deviate from the natural rate – for example, if there are so-called ‘trade-off inducing shocks’. These are best thought of as shocks that would still move inflation away from target even if we were to perfectly match demand and supply. Such shocks include a 5  All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx  5  shock to the exchange rate or to competition and firms’ mark-ups. Nevertheless, the natural rate remains useful to policymakers as a reference point for assessing the tightness or looseness of the monetary policy stance. 5  The natural rate of interest cannot be observed directly any more than the trend real rate. It can be estimated through economic models though the estimates are sensitive to the models used. Bank of England estimates, using a variety of models, suggest that the natural rate fell very sharply below the trend real rate during the financial crisis.
Unlike the post crisis period when policy rates would have needed to be deeply negative to follow the natural rate, monetary policy is now more able to be close to the natural rate and so to keep demand and supply in balance. But it can only do so with very low interest rates or, in the case of some advanced economies, with slightly negative rates and QE. There is a simple cross check on the model estimates of the natural rate – the actual evolution of inflation, output and interest rates over the past few years. The natural rate as John H Williams observed in response to Keynes and with some despair, is:  5  See Figure 1 at the end of the speech for an illustrative breakdown of some of the factors affecting the appropriate real policy rate. 6  For example, see http://bankunderground.co.uk/2015/08/11/an-estimate-of-the-uks-natural-rate-of-interest/. 6  All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx  6  “an abstraction; like faith it can only be seen by its works. One can only say that if the Bank policy succeeds in stabilizing prices, the bank rate must have been brought into proper line with the natural rate, but if it does not it must not have been.”  7  In the period since the UK recovery gathered pace in 2013 and the August Inflation Report this year, Bank rate was at ½% and the stock of QE unchanged.