Introduction
Before 2008, nobody argued about the neutral interest rate. It was textbook macroeconomics: the neutral real rate (r) roughly equals trend real economic growth (g). For Australia, that meant r around 3-4%. Add the inflation target of 2.5%, and you get a nominal neutral rate of 5.5-6.5%.
The RBA cash rate averaged about 5.5% from 1993 to 2007, bouncing around neutral as the economy cycled through expansions and contractions. Rates went up when inflation threatened, down when growth weakened, but always gravitating back to that 5-6% centre of gravity.
This wasn't controversial. It was Econ 101.
Then Lehman Brothers collapsed, and everything we thought we knew about interest rates went out the window.
The Emergency That Never Ended
The Global Financial Crisis triggered emergency rate cuts worldwide. The RBA slashed the cash rate from 7.25% in August 2008 to 3% by April 2009. This was appropriate crisis response – cutting rates aggressively to prevent a depression.
The expectation was that rates would normalise once the emergency passed. They never did.
From 2009 to 2023, the RBA cash rate averaged around 2%. Even allowing for terms-of-trade tailwinds from the China mining boom, this was well below any plausible estimate of neutral. It wasn't a temporary deviation; it was fifteen years of policy running persistently below equilibrium.
Asset markets noticed. Australian house prices roughly doubled. Global equity markets hit record after record. Yield-starved investors piled into ever-riskier assets, from high-yield bonds to cryptocurrency. These weren't random bubbles – they were the logical consequence of rates being held below their natural level for over a decade.
But here's the question nobody could agree on: Were rates actually below equilibrium? Or had equilibrium itself fallen?
The Secular Stagnation Thesis
In 2013, Larry Summers revived an old idea: secular stagnation. His argument was that the neutral rate had permanently declined due to structural changes in the global economy.
The story went like this: A global savings glut – driven by ageing populations saving for retirement, rising Asian savings rates, and increasing inequality pushing income to high-savers – meant there was too much capital chasing too few investment opportunities. Meanwhile, the tech economy required less physical capital than the old manufacturing economy. A software company needs servers; a steel company needs blast furnaces. [Although the recent AI investments suggest software companies are no longer in this situation].
The result, Summers argued, was that r had fallen to somewhere between 0.5% and 1.5%. If true, the neutral nominal rate was only 3-4%. The "low" rates of the 2010s weren't emergency policy – they were simply appropriate for a changed world.
This became the dominant view among central bankers and economists through the 2010s. Low rates weren't a bug; they were a feature of the new normal. Anyone expecting a return to 5-6% rates was living in the past.
The Arbitrage Problem
There's a problem with this story, and it's a basic one: standard economic theory says r should approximately equal trend growth. This isn't an assumption – it falls out of optimising models of consumption and saving. In equilibrium, the return on saving should equal the economy's growth rate.
Australia's trend real GDP growth is around 2.2%. If r genuinely fell to 1% while growth stayed at 2.2%, we have a puzzle. If you can borrow at 1% (real) and the economy grows at 2.2%, that's an arbitrage opportunity. Borrow, invest in literally anything that tracks GDP growth, and pocket the difference. Free money.
Governments certainly noticed. The argument that debt doesn't matter when $r < g$ became fashionable precisely because rates were held below growth for so long. But the fact that this arbitrage existed suggests something was mispriced – either rates were too low, or growth was artificially propped up.
And if rates were too low, we'd expect to see distortions. We did. House prices exploded. Equity valuations hit historic highs relative to earnings. Investors desperate for yield funded increasingly speculative ventures. The everything bubble wasn't a coincidence – it was the predictable consequence of rates held below equilibrium.
Note: the gap between borrowing costs and growth wasn't directly arbitrageable – credit spreads, volatility, and funding risk stood in the way. But this explains the persistence, not the absence, of distortion. Those who could bear those frictions – governments, leveraged investors, the already-wealthy – extracted the spread through asset appreciation. Those who couldn't – savers, the credit-constrained, the young – paid for it through compressed deposit rates and inflated asset prices. The arbitrage was statistical, not mechanical, which is precisely why it took fifteen years and an inflation shock to force a correction.
The Inflation Test
The secular stagnation thesis makes a testable prediction: if r truly equals 1% and the neutral nominal rate is around 3.5%, then running rates at 3.6% should be slightly restrictive. We should see inflation falling back to target and the economy cooling toward potential.
Inflation remains sticky, only recently falling back into the target band, before turning higher again. By late 2025, core measures had drifted back above 3% – despite the RBA holding rates at levels supposedly above neutral. If policy were genuinely restrictive, this shouldn't be happening.
This is evidence. If the neutral rate were really 3.5%, a cash rate of 3.6% would constitute tight policy. Inflation would be falling faster. The economy would be softer. The fact that inflation has been stubborn suggests policy isn't actually restrictive – which means neutral must be higher than 3.5%.
The inflation of 2022-2024 is the experiment the secular stagnation thesis needed. It failed the test.
Two Interpretations
We're left with two competing interpretations of the past fifteen years:
The secular stagnation view: r has permanently fallen to around 1%. The neutral nominal rate is roughly 3.5%. The low rates of 2010-2023 were appropriate for a changed world. Current rates around 3.6% are at or above neutral. Post-pandemic inflation was a supply shock that's now resolving.
The post-emergency view: r still equals trend growth, around 2.2%. The neutral nominal rate is roughly 4.7%. The low rates of 2010-2023 were prolonged emergency policy, mispricing risk and inflating asset bubbles. Current rates at 3.6% are still below neutral, which is why inflation has been sticky.
My modelling supports the second view. Using a joint NAIRU and output gap model estimated on Australian data, the trend neutral rate comes out around 4.7% – having declined from about 6.5% in the late 1980s as productivity growth slowed. Different specifications shift this modestly, but none produce a stable neutral below 3.5% post-pandemic.
Defenders of a low r point to safe-asset scarcity and regulatory demand for government bonds as compressing yields. This is a real phenomenon – but it explains why long-term rates fell, not why policy rates could remain below growth for a decade without eventually fuelling asset and then consumer inflation. The post-pandemic inflation surge is precisely what theory predicts when rates are held below neutral for too long.
A Shifting Consensus
This isn't a fringe view. Harvard's Kenneth Rogoff has been arguing since late 2023 that the era of ultra-low rates is over-that soaring debt, deglobalisation, defence spending, and the energy transition will keep rates elevated for the foreseeable future. More striking is the shift from Larry Summers himself. The architect of the secular stagnation thesis now concedes it may have been a phase, comparing those who expect a return to near-zero rates to the economists who wrongly predicted stagnation after World War II. Even the RBA acknowledges that estimates of the neutral rate have risen since the pandemic. The debate isn't settled – Olivier Blanchard still sees higher rates as an interlude – but the intellectual tide is turning. The lower forever consensus that dominated the 2010s is fracturing under the weight of evidence.
What Comes Next?
If r really does equal trend growth, then as the post-GFC emergency finally ends, we should expect interest rates to settle somewhere around 4.5-5%. Rates "starting with four" aren't tight policy. They're normal.
This is an uncomfortable message for anyone who bought property, took on debt, or built a business model assuming 2% rates would last forever. The adjustment will be painful. But returning rates to equilibrium is necessary for a healthy economy – one where asset prices reflect fundamentals rather than cheap money, where savings earn a real return, and where capital flows to productive uses rather than speculative ones.
The secular stagnation thesis offered comfort: the world has changed, low rates are permanent, adjust your expectations downward. The alternative is harder: the world hasn't changed that much, we just ran emergency policy for fifteen years, and now we have to readjust upward.
The evidence – persistent inflation despite "high" rates, r approximating growth as theory predicts, asset price behaviour consistent with mispricing – favours the harder interpretation. Fifteen years of emergency policy created a generation of investors, homeowners, and policymakers who think 2% rates are normal and 4% is punitive. They're wrong.
The emergency is ending. Time to recalibrate.
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