How the Federal Reserve Painted Itself Into A Corner

Recent musings by John C. Williams, President at the San Francisco Federal Reserve Bank, look at the rather arcane concept of r* (r-star) or the natural interest rate.  The natural interest rate is defined as the short-term real rate of interest that balances monetary policy so that it is neither accommodative nor contractionary in terms of growth and inflation.  In other words, this abstract concept is extremely important to central bankers because it keeps the economy in balance, preventing it from both overheating or underperforming.  According to his fellow economists at the Richmond Fed, the natural rate of interest is "a key concept in monetary economics because it allows economists to assess the stance of monetary policy".  While that all sounds very clear cut, in fact, it is not.  The economists at the Richmond Federal Reserve Bank note that the natural interest rate cannot be observed, it must be calculated using identifying assumptions.  Before we look at John Williams' comments, let's look at a bit of background information about the natural interest rate, how it is calculated, how it has changed over time and how accurate the calculations are.

The aforementioned paper by Lubik and Matthes at the Richmond Federal Reserve Bank goes on to compare two methods of calculating r-star.  The first method, the Laibach-Williams method, was developed by two Federal Reserve economists in 2003 using a:

 "...state space model to calculate the fundamentally unobservable natural rate from actual data by specifying simple theoretical relationship that links interest rates to measure of economic activity."  

The authors go on to state that:

"This relationship has an economic foundation in a traditional Keynesian model, where movements in the real interest rate affect consumption and investment decisions. For example, an increase in the real rate due to a hike in the federal funds rate would, when prices are sticky, reduce consumption and investment. A similar relationship can be derived from a more modern forward-looking framework where real rate movements affect intertemporal household decisions on savings and portfolio allocation."

Here's a graphic showing how the natural rate of interest has changed over time according to the Laubach-Williams method:

It is interesting to note that this method shows that the natural rate of interest has been negative since 2011.  The Laubach-Williams model shows that the current Federal Reserve monetary policy is not tight enough, that economic output is running above its potential and that any inflationary pressures could be controlled by raising the federal funds rate.

In the second method, the time-varying parameter vector autoregressive or TVP-VAR model, the evolution of economic variables are examined over a period of time.  This results in a curve as such (shown in black as compared to the Laubach-Williams curve in red):

Notice the dashed lines?  These are the 90 percent confidence lines.  In other words, the brilliant minds at the Federal Reserve are only certain of the accuracy of their estimate of the natural interest rate to within two percentage points above and below their calculated value which, since the Great Recession, has been around zero (i.e. the margin of error is about where the level of the natural interest rate has been since the 1990s!).  For such a key central bank concept, their margin of error is rather appalling.  If you are interested in reading additional material about what is wrong with the very concept of natural interest rates, here is an article on Mises that you may find useful.

Now, that we have that background, let's go back to John Williams' musings.  In his Economic Letter, he includes the following diagram showing how natural interest rates have declined for all advanced economies:

He suggests that the drop in the natural interest rate was precipitated by several factors:

1.) the global supply and demand for funds including shifting demographics (i.e. aging populations looking for safe assets)

2.) slower trend productivity and economic growth

3.) a global savings glut

4.) emerging markets seeking massive reserves of safe assets

He suggests that interest rates are going to stay lower than they have in the past by at least a percentage point or more even when the economy is performing at full strength and central bank monetary policy is neutral (i.e. not trying to stimulate or slow down the economy).

Here is the key paragraph from his Letter:

"The critical implication of a lower natural rate of interest is that conventional monetary policy has less room to stimulate the economy during an economic downturn, owing to a lower bound on how low interest rates can go. This will necessitate a greater reliance on unconventional tools like central bank balance sheets, forward guidance, and potentially even negative policy rates. In this new normal, recessions will tend to be longer and deeper, recoveries slower, and the risks of unacceptably low inflation and the ultimate loss of the nominal anchor will be higher.  We have already gotten a first taste of the effects of a low r-star, with uncomfortably low inflation and growth despite very low interest rates. Unfortunately, if the status quo endures, the future is likely to hold more of the same—with the possibility of even more severe challenges to maintaining price and economic stability." (my bold)

While the very concept of the natural interest rate may seem arcane to the vast majority of us, to central bankers, it is the key to their future monetary policies and how they will control the economy in a future economic slowdown, a problem that may lie just around the corner.  

Let's close this posting with a quick quote that looks at one of President Williams' solutions to the problem of a low r-star environment:

"...the most direct attack on low r-star would be for central banks to pursue a somewhat higher inflation target. This would imply a higher average level of interest rates and thereby give monetary policy more room to maneuver. The logic of this approach argues that a 1 percentage point increase in the inflation target would offset the deleterious effects of an equal-sized decline in r-star." (my bold)

America's central bank, which has set a firmly entrenched two percent inflation target as a key part of its two part mandate, is now admitting that perhaps they have erred and need to allow inflation to rise by an additional 50 percent so that they have room to manoeuvre during the next recession.  It's an interesting and rather desperate turn of events when a central bank has painted itself into a monetary policy corner by keeping interest rates at the zero lower bound for too long, isn't it?  Ah, but you can always blame baby boomers, a global savings glut and emerging markets for your problems, can't you?