Yellen and Draghi's Policies Aren't So Easy After All

The rate of interest that puts the economy on a glide path is lower across Europe and North America

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Bad news for European Central Bank President Mario Draghi and Federal Reserve Chair Janet Yellen: their low-rate policies are juicing the economy a lot less than they would have in the past.

The level at which policy rates neither add stimulus nor curb demand has fallen the world over, according to new research by Federal Reserve Board economists Kathryn Holston and Thomas Laubach and San Francisco Federal Reserve President John Williams. The so-called "neutral" or "natural" rate dipped to negative 0.4 percent in Europe in 2015, down from 2 percent in 2007, and 0.4 percent in the U.S.,  versus 2.3 percent. It stands at 1.4 percent  in the U.K. and Canada.

0623 new neutral

The country-by-country estimates move together over time, "suggesting an important role for global factors in shaping trend growth and natural rates of interest," the researchers write.

The rate estimates don't include inflation, so factoring in price pressures, policy is still accommodative. Adding the estimate of the neutral rate to core inflation — which was up 1.6 percent in April from the prior year — the neutral rate would be closer to 2 percent. The Fed has kept the benchmark lending rate at just 0.37 percent for this year.

The ECB's case is less clear-cut, because it has multiple policy rates: the deposit facility rate stands at -0.4 percent while the refinancing rate is zero and the marginal lending rate is 0.25 percent. Core prices there rose 0.8 percent in May from a year earlier, so neutral would lie just a bit above zero.

While the findings mean that even negative rate policy may not be all that accommodative in the eurozone, policy overall is: Draghi and his colleagues are making massive government and corporate debt purchases and offering free cash to European banks through four-year, zero- interest loans. The thing is, it's requiring such unconventional measures to really bring stimulus to the table these days.

The authors write "very low natural rates of interest, if sustained into the future, have profound implications for monetary policy,'' because "all else equal, a lower average real interest rate in turn implies that episodes of monetary policy being constrained at the effective zero lower bound are likely to be more frequent and longer."

Basically, their point is this: if the interest rate that puts the economy on a glide path is lower, it means central banks aren't going to be able to pull rates very far above zero. When a crisis hits, that will give them less ammunition to fight it, because they won't be able to cut their policy rate sharply to spur more lending and spending in the economy. That means they'll have to turn to more innovative methods — think large-scale bond purchases and negative rates — to try to stoke growth. 

That's a big deal, because while typical rate cuts are tried and true as monetary policy, both the efficacy and the side effects of these new, alternative options are still being studied.

There are two important caveats here. First, these estimates are highly uncertain, because the natural interest rate is a theoretical concept and it's hard to pinpoint with precision. Second, the natural rate moves over time, so there's a possibility that stronger economic growth down the road could shift it back up — though the authors find "no evidence" that's it's ticked up in the U.S. recently, even seven years into the economic expansion. 

A new, lower global rate situation has implications for how central banks interact if it persists.

"In an environment of a very low natural rate of interest, the effects of the lower bound on interest rates are amplified and international spillovers and the benefits from international policy coordination may increase," the authors wrote.

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