The Tectonic Shift: Re-evaluating the Euro Area’s Natural Rate of Interest in a Post-Pandemic World

The post-2022 macroeconomic environment has been characterized by a surge in nominal interest rates across advanced economies, including the Euro area. This paper posits that a superficial analysis attributing this surge solely to inflationary pressures and the corresponding monetary policy reaction is incomplete. By decomposing long-term, market-based interest rates, we reveal a persistent and significant rise in the real rate component, a finding that challenges the pre-pandemic narrative of secular stagnation. We juxtapose this market-based evidence with model-based estimates of the Euro area's real natural rate of interest (r∗), which, despite considerable uncertainty, exhibit a concomitant and sharp reversal from their historic lows. We argue that these parallel movements are not coincidental but rather signal a potential structural upshift in the Euro area’s underlying equilibrium real rate. This paper explores the primary drivers of this putative regime shift, including a more expansionary fiscal stance, the capital-intensive green and digital transitions, geoeconomic fragmentation, and a potential inflection point in productivity. The implications of a durably higher r∗ are profound, fundamentally altering the calculus for monetary policy, fiscal sustainability, and asset valuation in the Euro area for the decade to come.

1. Introduction: The End of an Era?

For over a decade preceding the COVID-19 pandemic, the dominant macroeconomic narrative in the Euro area, as in other advanced economies, was that of secular stagnation. This hypothesis, revitalized by Summers (2014), posited a chronic excess of desired saving over desired investment, leading to a persistent depression of the real natural rate of interest, r∗. This rate—the theoretical real interest rate that equilibrates the goods market at full employment and stable inflation—is the lodestar for monetary policy. Its protracted decline, with estimates plumbing deep into negative territory, constrained central banks, pinning them against the effective lower bound (ELB) and necessitating the deployment of unconventional policy tools like large-scale asset purchases.

The landscape since 2022 appears dramatically different. In response to the highest inflation in a generation, the European Central Bank (ECB) embarked on its most aggressive monetary tightening cycle in history. Superficially, the sharp rise in sovereign bond yields and other market rates could be seen as a simple, cyclical response to this policy action. However, a more granular analysis suggests a more profound, structural transformation may be underway.

This paper presents evidence that the recent increase in long-term nominal interest rates in the Euro area is not merely a transient phenomenon driven by inflation expectations. Instead, it is increasingly underpinned by a durable rise in the long-term real rate component. This market signal finds a compelling echo in updated model-based estimates of r∗, which show a marked reversal from their nadir. We contend that the Euro area may be witnessing a structural break from the secular stagnation era, driven by a confluence of powerful new economic forces. This analysis proceeds in four parts. Section 2 delineates the theoretical framework connecting the unobservable r∗ to its observable market-based proxies. Section 3 presents the core empirical evidence, deconstructing the recent surge in Euro area interest rates and examining the trajectory of model-based r∗ estimates. Section 4 offers a deep dive into the potential structural drivers of this reversal, from fiscal paradigms to technological and geopolitical shifts. Finally, Section 5 explores the far-reaching implications of a higher r∗ for the conduct of monetary policy and broader financial stability.

2. Theoretical Foundations: The Natural Rate and its Market Correlates

To comprehend the potential shift in the macroeconomic regime, it is essential to first establish the theoretical linkages between the abstract concept of the natural rate and the concrete data observed in financial markets.

2.1 The Wicksellian Natural Rate of Interest (r∗): A Conceptual Anchor

The concept of a "natural" rate of interest originates with Knut Wicksell (1898). In his framework, the natural rate is the real interest rate consistent with a stable price level. In modern New Keynesian macroeconomic models, this concept is refined: r∗ is the real interest rate that would prevail if prices were fully flexible and the economy were operating at its potential output. It is the rate that balances aggregate demand and aggregate supply, or equivalently, desired savings and investment, without generating inflationary or deflationary pressure.

The output gap, yt​−yt∗​, is a function of the deviation of the real policy rate, rt​, from the natural rate, rt∗​:

yt​−yt∗​=−α(rt​−rt∗​)+ϵt​

where α>0 and ϵt​ is a demand shock. When the real rate is below the natural rate (rt​<rt∗​), policy is expansionary, stimulating demand and pushing output above potential, which in turn puts upward pressure on inflation. Conversely, when rt​>rt∗​, policy is contractionary. Therefore, r∗ serves as the crucial, albeit unobservable, benchmark against which the stance of monetary policy is judged.

2.2 The Fisher Equation and Market-Based Decomposition

While r∗ is a theoretical construct, financial markets provide a window into its expected future path. The nominal interest rate on any asset can be decomposed using the Fisher equation. For an n-period risk-free nominal bond, the yield, it,t+n​, can be expressed as the sum of the expected average real rate, expected average inflation, and various risk premia:

it,t+n​=Et​[n1​k=0∑n−1​rt+k​]+Et​[n1​k=0∑n−1​πt+k+1​]+IRPt,t+n​+LPt,t+n​

Here, Et​[⋅] is the expectation operator at time t, rt​ is the short-term real rate, πt​ is the inflation rate, IRP is the inflation risk premium (compensating investors for uncertainty about future inflation), and LP is a liquidity premium.

Practically, financial instruments allow for the extraction of these components. The Overnight Index Swap (OIS) rate is considered the best available proxy for the risk-free nominal rate, as it has minimal credit risk. Inflation-linked swaps (ILS) provide a direct market measure of inflation expectations (πe) plus the inflation risk premium. The difference between the nominal OIS rate and the ILS rate for the same maturity gives a measure of the market-implied real rate, which includes the expected future real rate and a (typically negative) liquidity premium. The inflation component derived from these swaps is often termed inflation compensation.

iNominal OIS Rate​​≈rImplied Real Rate​​+πe+IRPInflation Compensation​​

The 10-year real rate derived from this decomposition is particularly informative. It reflects the market's perception of the average real interest rate over a long horizon, which should theoretically be anchored by expectations of the long-run natural rate, r∗.

3. Empirical Evidence: A Tale of Two Rates

The confluence of market-based and model-based evidence forms the core of our argument for a structural shift. The two charts provided offer a powerful visual narrative of this change.

3.1 Deconstructing the Post-Pandemic Yield Surge

The first chart, "10-year euro area OIS rate decomposition," plots the cumulative change in the 10-year nominal OIS rate and its constituent parts—the real rate and inflation compensation—since January 2022. This period captures the entirety of the ECB's tightening cycle and the associated market repricing.

An examination of the chart reveals a distinct two-phase process:

• Phase 1 (January 2022 - Mid-2022): The Inflation Shock. The initial surge in the nominal rate (the blue line) was driven by a substantial increase in both components. However, the rise in inflation compensation (the yellow area) was particularly pronounced. This reflects the market's reaction to the outbreak of war in Ukraine, soaring energy prices, and broadening inflationary pressures. The market was pricing in a de-anchoring of inflation expectations and demanding higher compensation for this risk.

• Phase 2 (Mid-2022 - Early 2025): The Real Rate Dominance. From the second half of 2022 onwards, the dynamic shifted decisively. Inflation compensation stabilized and even trended slightly downwards from its peak, suggesting that the ECB's aggressive policy response was successful in re-anchoring long-term inflation expectations around its 2% target. Yet, the nominal rate continued to climb, reaching new peaks into late 2023 before moderating. The chart makes it unequivocally clear that this second phase was driven almost entirely by the persistent and substantial increase in the real rate component (the orange area).

This is a critical observation. A temporary rise in real rates would be expected during a monetary tightening cycle. However, the sheer persistence and magnitude of the increase in the 10-year real rate implies that the market is not simply pricing in a temporary period of tight monetary policy. Rather, it is adjusting its expectation for the level of the real rate over the entire next decade. This suggests a revision of the perceived long-run neutral stance of monetary policy, and by extension, a revision of the underlying natural rate, r∗. The market's pricing behavior is consistent with the belief that the equilibrium rate itself has risen.

3.2 Model-Based Estimates of a Reversing r*

The second chart, "Euro area real natural rate of interest estimate," provides the crucial corroborating evidence from a structural modelling perspective. These estimates are typically derived from multivariate time-series models, such as the widely cited Holston-Laubach-Williams (2017) model, which infers r∗ from the observed relationships between output, inflation, and interest rates.

This chart documents two distinct eras:

• The Secular Decline (2008 - c. 2021): The period from the Global Financial Crisis to the pandemic was characterized by a relentless, secular decline in the estimated r∗. The central estimate fell from approximately 2% in 2008 to a trough of around -2% in the wake of the pandemic. This long decline provided the empirical backbone for the secular stagnation thesis and justified the ECB's increasingly unconventional monetary policy stance.

• The Sharp Reversal (c. 2022 - 2024): Coinciding precisely with the period of rising market-based real rates, the model-based estimate of r∗ exhibits a dramatic V-shaped recovery. From its nadir, the estimate has surged upwards, moving out of deeply negative territory and approaching the zero bound, and potentially positive territory, by 2024.

It is crucial to acknowledge the profound uncertainty surrounding these estimates, as illustrated by the wide confidence bands (the light blue shaded areas). r∗ is not directly observable and must be filtered from the data, a process sensitive to model specification and endpoint problems. Nevertheless, the directional shift in the central tendency is striking. The entire distribution of plausible r∗ estimates has shifted upwards. The fact that this model-based inference, relying on macroeconomic aggregates, aligns so closely in time with the independent, high-frequency signal from financial markets (Chart 1) strengthens the hypothesis that a genuine structural change is occurring. The persistent rise in real market rates is not just noise; it appears to be reflecting a fundamental shift in the economy's underlying equilibrium, a shift that econometric models are now beginning to capture.

4. Drivers of a Potential Structural Shift in the Euro Area Natural Rate

If the natural rate is indeed rising, it must be driven by structural changes in the determinants of saving and investment. We identify four primary candidates that, in concert, may be powerful enough to reverse a decade-long trend.

4.1 The Fiscal Stance: From Austerity to Expansion

The post-GFC era in the Euro area was dominated by fiscal consolidation and austerity. This has changed fundamentally. A new, more proactive fiscal paradigm has emerged, increasing the demand for loanable funds and placing upward pressure on r∗.

• NextGenerationEU (NGEU): This €750 billion recovery fund, financed by common EU debt issuance, represents a landmark shift towards a centralized fiscal capacity. It is explicitly geared towards public investment in the green and digital transitions, directly boosting investment demand.

• REPowerEU and Increased Defense Spending: Russia's invasion of Ukraine has catalyzed massive public investment plans to accelerate the energy transition away from Russian fossil fuels (REPowerEU) and to significantly increase defense expenditures across member states. This "geopolitical dividend" translates into higher government spending and borrowing for years to come.

From the perspective of a simple loanable funds framework, this sustained increase in public investment and spending shifts the total investment demand curve to the right. In an IS-LM model, it represents a persistent positive shock to the IS curve. All else equal, this requires a higher equilibrium real interest rate to clear the market. This marks a clear structural break from the fiscally constrained environment of the 2010s.

4.2 The Green and Digital Transitions: An Investment Demand Super-cycle

Beyond public initiatives, the private sector is facing an unprecedented need for capital expenditure to meet climate goals and adapt to digitalization.

• The Green Transition: The legally binding target of climate neutrality by 2050 necessitates a complete overhaul of the Euro area's energy, transport, industrial, and building infrastructure. Estimates of the additional investment required run into hundreds of billions of euros per year. This represents a massive, sustained, and largely non-discretionary positive shock to private investment demand.

• Digitalization and AI: The imperatives of strategic autonomy and competitiveness are driving substantial investment in semiconductor production, cloud infrastructure, and the adoption of artificial intelligence. These technologies are capital-intensive and have the potential to boost productivity, further increasing the marginal product of capital and the desired level of investment.

This combined wave of investment can be conceptualized as a positive technology and preference shock that raises the desired capital stock for any given interest rate, thus pushing up r∗.

4.3 Geoeconomic Fragmentation and Supply Chains

The pre-pandemic era was characterized by hyper-globalization, which contributed to downward pressure on r∗ through the "global savings glut" hypothesis (Bernanke, 2005). Abundant savings from emerging markets, particularly China, sought safe assets in advanced economies, depressing their equilibrium interest rates. Several forces are now working to reverse this dynamic.

• Deglobalization and "Friend-shoring": Geopolitical tensions are leading firms to re-evaluate and re-shore their supply chains for greater resilience. Duplicating supply chains is inherently inefficient and capital-intensive, representing another source of increased investment demand.

• Shifting Savings Patterns: As China's economy transitions towards domestic consumption and its population ages, its contribution to the global savings pool may diminish. Simultaneously, the need for investment in new trade partners and domestic production reduces the net supply of savings available to the Euro area from abroad.

This geoeconomic fragmentation effectively shrinks the relevant pool of global savings accessible to finance domestic investment, increasing the equilibrium cost of capital within the Euro area bloc.

4.4 Productivity and Demographics: A Reassessment

Finally, the long-term structural anchors of r∗—productivity growth and demographics—may also be at an inflection point.

• Productivity: While the data is still nascent, there is a plausible argument that the productivity benefits of digitalization and AI may finally be materializing after a long period of gestation, akin to the delayed impact of electrification in the early 20th century. A structural increase in the trend rate of productivity growth would directly translate into a higher marginal product of capital and thus a higher r∗.

• Demographics: The standard view is that aging populations depress r∗ by increasing the aggregate desire to save for retirement. However, the dynamic may be more complex. As large baby boomer cohorts move from saving to dissaving in retirement, they will be drawing down assets to fund consumption. This shift could, for a period, reduce the net supply of savings, putting upward pressure on rates. The overall effect is ambiguous, but the simple narrative of aging-as-a-depressant for r∗ may need refinement.

5. Navigating in the Dark: Policy under Structural Uncertainty

The proposition that the Euro area's natural rate of interest is structurally higher is not an academic curiosity; it is a hypothesis with profound and immediate consequences for policymakers, even if it remains shrouded in the fog of uncertainty characteristic of real-time macroeconomic assessment. A durable rise in r∗ would reshape the operational environment for the ECB and fiscal authorities, representing a paradigm shift away from the challenges of the last decade.

The most direct consequence is a recalibration of the monetary policy stance. The neutral nominal policy rate, R∗, is the sum of the natural real rate and the central bank's inflation target (R∗=r∗+π∗). If r∗ has risen from, say, -1% to 0.5%, then the neutral policy rate for a 2% inflation target has shifted from 1% to 2.5%. This implies that a policy rate that was considered highly restrictive under the old regime may be only moderately so, or even neutral, under the new one. This fundamentally alters the assessment of whether current policy is sufficiently tight to ensure inflation's timely return to target and informs the debate on the appropriate "terminal rate" for the hiking cycle and the subsequent pace of any normalization.

Furthermore, a higher r∗ provides a welcome escape from the tyranny of the effective lower bound (ELB). With a larger buffer between the neutral rate and the ELB, the central bank has more conventional policy space to combat future disinflationary shocks. The probability of needing to resort to unconventional tools like quantitative easing or negative interest rates in the next downturn would be significantly reduced, restoring the primacy of the policy rate as the main instrument of monetary control.

However, this new landscape is not without its perils. For fiscal authorities, a permanently higher real interest rate presents a formidable challenge to fiscal sustainability. The dynamics of public debt are highly sensitive to the differential between the real interest rate and the real growth rate (r−g). A rise in r tightens the government's intertemporal budget constraint, requiring higher primary surpluses to stabilize or reduce debt-to-GDP ratios. Sovereigns that entered this new era with high debt burdens will face heightened market scrutiny and a greater risk of adverse debt dynamics, potentially reawakening dormant concerns about financial fragmentation within the union.

Finally, a structural increase in the risk-free discount rate would reverberate across all asset classes. The valuation of assets—from equities and corporate bonds to real estate—is predicated on discounting future cash flows. A higher r∗ as a baseline component of the discount rate implies, all else being equal, lower present values. This could precipitate a slow-motion but significant repricing across the financial system, creating headwinds for wealth creation and potentially exposing vulnerabilities in sectors that have become accustomed to an environment of perpetually low rates. The challenge for policymakers, therefore, is one of navigation under immense uncertainty. Acting as if r∗ has risen when it has not risks choking off the recovery, while failing to recognize a genuine structural shift risks un-anchoring inflation. The signals from market and model-based rates, while noisy, are aligned and compelling. They suggest that the assumptions that guided policy for over a decade may no longer hold, and that the Euro area has entered a new and more challenging macroeconomic chapter.