By Rich Miller
When the U.S. was struggling out of its last recession 10 years ago, inflation phobes at the Federal Reserve and on Wall Street were obsessed with something called the Non Accelerating Inflation Rate of Unemployment. Widely known as Nairu, this was supposed to be the economy's natural rate of joblessness. If unemployment fell below the 6% Nairu, or so the theory went, inflation was sure to rise.
Now, with Nairu mostly discredited--unemployment, after all, fell to 3.9% in the last expansion while inflation barely budged--the buzz in financial circles is about a different kind of natural rate: the natural rate of interest. Backers of this theory believe there is an equilibrium interest rate at which the economy experiences the best combination of growth and inflation.
As long as the Fed holds rates at that level, everything is copacetic. But if rates stay below that point for an extended period, watch out. The economy will overheat and inflation will rise. Known as R Star to cognoscenti within the Fed, the natural, or neutral, rate is widely thought to be 4.5% or more--well above the central bank's current 1.75% target for the interbank federal funds rate.
Like Nairu before it, this simple-minded model poses dangers for the economy. If Fed policymakers buy too heavily into its theoretical framework and jack up interest rates prematurely, they'll end up stifling the economy needlessly. So far, that doesn't seem to be happening. But as the economy plows ahead in the coming months, the pressure inside the Fed for a return to a more natural rate of interest will increase, and the chances of a misstep by the central bank will grow.
Indeed, the chatter about the natural rate of interest is already having a deleterious effect on the economy, through the financial markets. Although the recent shakiness of the stock market and a rise in the March unemployment rate have persuaded investors that the Fed won't tighten credit at its next meeting on May 7, that's seen only as a temporary reprieve. Convinced that the central bank must raise rates to their natural level soon now that the economy is on the upswing, the markets are betting on a virtual doubling of the fed funds rate by next January, with more increases in the following months. That has pushed up long-term interest rates, choking off the mortgage-refinancing boom that helped the economy weather last year's recession.
Wall Street analysts use a simple rule of thumb to arrive at their estimate of the natural rate of interest. Over the last 40 years, through all the ups and downs of the economy, the real fed funds rate, after stripping out inflation, has averaged 2 1/2% to 3%. Throw in a 2% inflation rate on top of that and, voila, you have a 4 1/2% to 5% fed funds target for Fed Chairman Alan Greenspan and his team to shoot for next year. The Fed's own analyses are much more sophisticated but arrive at more or less the same place as do Wall Street's back-of-the-envelope calculations.
The trouble, as even some Fed officials admit, is that the economy is a lot more complicated than the R Star proponents inside and outside the central bank suggest. It's not feasible for the Fed simply to commit itself to a single rate of interest. Besides, whatever the natural rate of interest is, it's not static. It varies in line with longer-term shifts in the economy and financial markets. Depending on how things shake out in the current expansion, there's a chance that R Star could turn out to be lower than the markets currently project.
Work by central bank economists Thomas Laubach and John C. Williams found that the real equilibrium interest rate after inflation rose about 1 1/2 percentage points in the latter half of the 1990s. Part of that was the result of the surge in productivity. Companies stepped up their borrowing in order to buy computers and other efficiency-enhancing equipment. That put upward pressure on interest rates. But other factors were at work, most notably the booming stock market. As stock prices raced ever higher in the late '90s, investors shifted more and more money into shares and away from less risky bonds, elevating long-term yields. The stock market, through the so-called wealth effect, also triggered a buying and borrowing binge by consumers.
In the early '90s, Greenspan rejected the Nairu straitjacket that Fed inflation-phobes were pushing on him and held off from raising interest rates sharply as unemployment fell. As a result, the New Economy and the U.S. enjoyed a 10-year economic expansion. For the sake of the current recovery, let's hope he's as discriminating when it comes to the latest monetary fad of equilibrium interest rates.
Miller covers Fed policy and the economy from Washington.