The Search for the Elusive Natural Interest Rate
Financial markets are remarkably strong in a world roiled by terror attacks, a coup attempt in Turkey, murders of police officers in the U.S., and Britain’s historic vote to leave the European Union. The S&P 500 set a record on July 20 for the sixth time in eight sessions. Are investors ignoring how the real world will affect their investments? Or do they know something the rest of us don’t?
Actually, markets do share a bit of the world’s sour mood. Bullish sentiment is below average despite the big rise in stock and bond prices, according to the weekly survey from the American Association of Individual Investors. People are buying stocks because they have to put their money to work somewhere—and the main alternative, the bond market, seems to offer even lower future returns. Bonds accounting for more than one-third of the value of Bloomberg’s developed-economy sovereign-bond index are yielding less than zero.
What’s more, bond yields are low in large part because markets—and, crucially, central banks—have downgraded their forecasts for long-term economic growth. So what appears to be optimism in the financial markets is actually pessimism in disguise. Which is kind of depressing all by itself.
On July 26 and 27, the rate-setting Federal Open Market Committee of the Federal Reserve will meet in Washington. One question sure to be discussed behind closed doors is whether the lofty heights of the stock and bond markets can be traced to a mistake by the Fed.
The Fed aims to set short-term interest rates in relation to the “natural rate”—the one that would produce full employment without excess inflation. Some critics say the Fed has kept rates too low, thereby lifting stocks but at the risk of generating dangerous asset bubbles and setting the stage for above-target inflation. In this vision of the mysterious properties of interest rates, the Fed is like a medieval alchemist, trying to transmute the lead of pessimism and slow growth into the gold of capital gains on Wall Street.
Low rates have their place, but “if you push that lever too hard you can break the markets,” says Vincent Reinhart, a former top Fed staffer who’s chief economist of Standish Mellon Asset Management. Ben Hunt, the chief risk officer of Salient Partners, an asset management firm, told Bloomberg TV in June that the world’s central banks have too much power over markets. “We think that you should try to insulate yourself as much as you can from the casino that central bankers are running,” he said.
Esther George, whose opinion matters even more because she participates in FOMC debates as president of the Federal Reserve Bank of Kansas City, said in a July 14 speech in Oklahoma City that too-low rates “can give rise to imbalances or misallocation of capital that, over the longer term, can affect growth and can cost jobs.” Hers won’t be the only voice raised, if transcripts of past meetings of the rate-setting committee are any indication. The alternate view inside the Fed is that a premature increase is the greater danger. “I’d be quite worried that they were cutting us off from getting out of the muck by raising rates now,” says Kenneth West, an economist at the University of Wisconsin who specializes in monetary policy.
The natural rate of interest is a guide for monetary navigators. By keying off the natural rate, “a central bank is essentially trying to mimic the ideal conditions of an economy,” Jeffery Amato, an economist at the Bank for International Settlements in Switzerland, wrote in a working paper in 2005. If it could be located with certainty, monetary policy would be simple. The problem: The rate is invisible and not directly measurable. Unlike the indexes for adjustable-rate mortgages, there is no Bloomberg function that describes the natural rate of interest, and there are no derivatives based on its value.
Swedish economist Knut Wicksell advanced the concept of the natural rate in 1898. He said prices will be stable when long-term interest rates are set equal to the long-term rate of return on a nation’s capital stock, such as land, buildings, and machinery. His logic was that if interest rates were kept below the potential rate of return, investors would have a powerful incentive to exploit that gap by borrowing and investing every krona they could get their hands on—and to keep doing so until the economy ran out of workers and inflation heated up.
High inflation, then, is a clue that interest rates are below their natural level. High unemployment is the opposite, a sign that interest rates are above what nature intends and choking off growth. Such clues are the only way to infer the natural rate. “The natural rate is an abstraction; like faith, it is seen by its works,” the Welsh-born American economist John Williams wrote in 1931.
His metaphor, drawn from Protestant theology, appears in new research by another John Williams (no relation), who’s the president of the Federal Reserve Bank of San Francisco. He and Thomas Laubach, an economist on the staff of the Fed in Washington, have done some of the most careful estimates of the natural rate. They say it’s fallen sharply—by their estimate, it declined from about 5 percent in the 1960s to below 3 percent in the early 2000s. It then crashed along with the economy around 2008. Rather than recovering since, they estimate, it’s continued to drift lower, to below half a percent by the end of 2015. (All of these numbers strip out the effect of inflation.)
When Fed Chair Janet Yellen wants to explain why the Fed is keeping rates so low, she cites the natural rate. At the press conference following the FOMC’s June meeting, she said the neutral interest rate—which is essentially synonymous with the natural rate—“is quite depressed by historical standards.” She added: “I think all of us are involved in a process of constantly reevaluating where is that neutral rate going.”
Why the natural rate has fallen is a whole separate question. Laubach and Williams argue that slower projected economic growth is the biggest factor. West, who commented on their work at a conference earlier this year in Sofia, Bulgaria, puts more weight on an increase in the appetite for savings, a flight by investors to safe assets, falling inflation, and declining private and public investment.
What should monetary policymakers do if they don’t know the natural rate and therefore can’t be sure if rates are too high or too low? Avoid sudden moves, advises Kim Schoenholtz, director of the Center for Global Economy and Business at New York University’s Stern School of Business. “When you’re driving on a cliff road on a foggy night, you go slow, and that’s what they’ve been doing,” he says.
Schoenholtz says that means avoiding precautionary rate changes and moving only when there’s clear evidence that rates are too high or low. And then, when the evidence is clear, moving a bit more rapidly—making perhaps half-percentage-point moves at each FOMC meeting rather than the quarter-point moves the markets are accustomed to.
It would also help if fiscal authorities pitched in. Keynesians favor tax cuts or spending increases to stimulate demand for goods and services. Others, who worry about adding to government indebtedness, emphasize structural changes that could boost growth, such as opening markets to competition. Either way, the point is that “central banks in the major economies are overburdened when all that’s being done is monetary policy,” says Reinhart, the Standish Mellon chief economist.
Natural rate theory has its critics. Reinhart says it has an unjustified air of scientific accuracy that treats market participants like white mice in an experiment. Wicksell himself wrote in 1906 that the term was “somewhat too vague and abstract.” Then again, there are no sure things. In a world as chaotic as this one has been lately, central bankers will cling to whatever thin reed they can find.