A new approach to measuring the natural rate of interest could help the Federal Reserve hit its inflation and employment targets more reliably than current methods, according to research published in August 2026 by the Federal Reserve Bank of San Francisco. The study introduces a medium-run measure that balances responsiveness to economic pressures with the stability needed for policy guidance. Current estimates place the medium-run real natural rate at around 1.5%, suggesting that monetary policy remains somewhat accommodative as of August 2026.
The research compares three policy approaches using simulated forecasts at a two-year horizon. When policymakers respond to a short-run natural rate without accounting for measurement error, unemployment stays on average 0.2 percentage points closer to target than when using the medium-run measure. But once estimation uncertainty is factored in—which affects short-run measures more severely—the medium-run approach performs better, keeping unemployment closer to target by just under 0.1 percentage point while reducing federal funds rate volatility from 2.1 to 1.6 percentage points on average. The medium-run natural rate dropped nearly 5 percentage points in the year following the 2008 financial crisis and fell almost 4 percentage points during the pandemic. By comparison, the Holston-Laubach-Williams r-star measure—a long-run benchmark—showed only modest declines during the crisis and barely responded to pandemic disruptions. With the federal funds rate target currently between 3.5% and 3.75% and inflation at 3%, the implied real rate of 0.5% to 0.75% sits below the 1.5% medium-run natural rate estimate.
The study argues that the medium-run measure offers three key advantages over existing benchmarks. First, it's more stable than short-run natural rate estimates, which are "notoriously volatile and imprecise." Second, it remains responsive enough to current conditions to guide policy effectively, unlike long-run measures that focus solely on persistent trends. Third, the report finds it provides earlier signals by reacting to economic pressures "before they fully materialize in inflation and unemployment data." The author notes that during the pandemic, medium-run estimates would have signaled the need to cut rates ahead of shifts in inflation and unemployment, preventing delays from waiting only for persistent shocks to appear.
The natural rate of interest represents the inflation-adjusted rate consistent with an economy at full capacity—a benchmark that helps determine whether policy is tight or accommodative. The report explains the concept through an analogy: "If the boat steers away in response to the visible part of the iceberg, then it may be too late and not nearly enough. However, if it can use sonar to estimate the size of the iceberg underneath, the boat can steer away in a more timely and effective way." The natural rate acts like sonar for underlying demand pressures beyond what's visible in current inflation and activity data. The medium-run measure achieves this by averaging short-run natural rate projections into the future, emphasizing fluctuations up to five years ahead—capturing persistent changes like r-star does while also responding to abrupt economic shifts.
Analysis of the model dynamics shows that when policy assumes a constant natural rate, the federal funds rate stays more stable, but misses of the dual mandate grow much larger. The simulations assume perfect knowledge of the true natural rate, which isn't realistic—policymakers work with imperfect measures subject to greater error for short-run estimates than for medium-run ones. After accounting for this measurement uncertainty, responding to the medium-run natural rate delivers better economic stabilization with less interest rate volatility. The study estimates the medium-run measure using data from 1987 through the fourth quarter of 2025 for inflation, growth, and interest rates, with 90% uncertainty bands showing the range of accuracy remains high. Even with that uncertainty, the research suggests the approach offers clearer forward-looking signals than waiting for observed data on inflation and activity to motivate slower policy adjustments over subsequent quarters.