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Powell Faces Big Question Mark In Natural Rate: Eco Research Wrap

Where the neutral rate lies will matter hugely for Fed policy

Call them the star wars. 

Debate is heating up over whether the Federal Reserve’s neutral interest rate -- commonly called r-star -- is about to head higher, and America’s monetary policy outlook hinges on who has it right.

In one corner, San Francisco Fed President John Williams and his co-authors think long-term factors are holding down the interest rate that neither stokes nor slows growth, so the Fed will have to stop lifting rates this cycle at a historically low endpoint. In the other, Goldman Sachs chief economist Jan Hatzius thinks the recent decline owes to cyclical factors and could reverse meaningfully, allowing the Fed to lift rates higher next year.

The intellectual showdown is relevant as Jerome Powell heads to Capitol Hill Tuesday for his first testimony as Fed Chair, and as central bank-watchers look eagerly for hints about how the new chief expects r-star to evolve.

In honor of Powell’s big day, we're leading off this week's economic research wrap with a summary of the recent neutral-rate literature, from both viewpoints. We also look at computerization and wages, a hopeful sign for rent relief, and babies as a recession indicator. Check this column each week for the latest economic studies from academics, central bankers, and Wall Street research desks.

Cyclical or Secular? 

Still More Cyclical than Secular
Published Feb. 26, 2018, available to Goldman Sachs subscribers
and Measuring the Natural Rate of Interest ReduxMeasuring the Natural Rate of Interest: International Trends and Determinants
Published 2015 and 2016

In Los Angeles last week, the Fed’s John Williams told reporters that while tax cuts might tweak the dial on neutral real rates, it would be a minor tick up at best: in a world of lower productivity and an aging population, r-star is unlikely to shift a lot higher. “I still think we’re in the realm of a movement in r-star that might be at most a quarter of a percentage point,” he said. “It wouldn’t get it from a half to 1.5 or 2, or a more normal level.” 

Goldman Sachs’s economics team disagrees. They say the model Williams uses to pinpoint the neutral rate relies on big assumptions – like the idea that rates should move in lockstep with potential growth – that could be wrong. By modifying the assumptions, they see r-star rising as high as 1.25 percent to 1.75 percent in coming years. That’s a lot more optimistic than the Fed consensus, which most recently placed it at 0.75.  

Who you believe is really important. If it’s true that the dip in r-star owes to temporary headwinds that will abate, there’s a lot of runway left for the Fed to hike. And if we’re able to get farther away from the zero lower bound before the next downturn, that will leave the Fed with more crisis-fighting ammunition.

There are early signs that the Fed view could change: Randal Quarles, the newest governor, said Monday that the natural rate could shift up if productivity improves, for instance. Market-implied estimates for the Fed’s longer-run rate are also shifting higher, so whether the Fed might update its thinking more broadly has become a pressing question as Powell goes before members of Congress. 

Costly computers

Computerizing Industries and Routinizing Jobs: Explaining Trends in Aggregate Productivity
Published February 2018
Available on the NBER website


Computers enabled major productivity improvements in routine jobs through the 1980s and 1990s,  and cut down the need for workers in many areas. By spurring efficiency improvement – good news for companies and bad news for anyone looking to pick up more hours – computerization accounted 4 out of 5 percentage points of the labor share decline, based on the researchers’ model. “Computer capital alone is more important than all other machinery and equipment in explaining the decline in the labor share,” the authors write. 

Weekly (demo)graphic: rent relief

The City by the – Crane? San Francisco Out-Builds All Other Markets in 2017
Published Feb. 22, 2018
Available on the Trulia blog 

San Francisco nearly doubled permits last year relative to its historical average, based on a new Trulia analysis, leading the country’s major cities when it comes to building activity. That was especially true for high-density units. That said, the Bay Area is notoriously stingy with its construction, so it started from a low base, and Dallas led the pack when it came to number of permits. 

Babies and recessions 

Is Fertility a Leading Economic Indicator?
Published February 2018
Available on the NBER website

What do inverted yield curves and hospital delivery units have in common? Turns out, fertility can predict recessions. A new National Bureau of Economic Research paper shows that “the growth rate of conceptions declines very rapidly at the beginning of economic downturns and the decline starts several quarters before recessions begin.” The pattern is true in the U.S. for the Great Recession and the 1990 and 2001 downturns. 

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