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Searching for the elusive neutral interest rate

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The Elusive Featured Image Scaled.jpg

Interest rates move trillion-dollar markets, influence politics, hit the value of currencies, and even affect the price of groceries. Central bank press conferences announcing interest rate decisions draw large audiences and generate enticing headlines like “Interest Rates Rising,” and experts use jargon like “soft landing” and “hard landing” to describe the expected outcomes of central bank policy decisions. But in an ideal world, where exactly should we land?

Economists and practitioners alike have been questioning this for 2019.Number In the 20th century, a Swedish economist Knut Wicksell He invented the concept of the natural rate of interest, also known as the neutral rate, equilibrium rate of interest, or r* (r-star). This is the interest rate at which monetary policy does not stimulate or restrict economic growth. It is important because central banks primarily use this rate to set monetary policy: whether to raise, lower, or maintain interest rates.

The neutral interest rate is compatible with stable price levels and maximum employment. When current interest rates are higher than r*, it means we are in a tight monetary environment where inflation will tend to fall. When current interest rates are lower than r*, it means inflation is likely to be higher.

The idea of ​​r* is very appealing: there is a rate that is equal to all saving and investment in the economy while keeping production at its maximum potential without inflation. This is where we want the economy to get to. No wonder there has been a lot of research in this area. The neutral interest rate can be thought of as the Holy Grail for central banks: the rate that guarantees low inflation without affecting employment. But like the Holy Grail itself, r* is very hard to find; it is elusive because it is unobservable.

With the Chairman of the Federal Reserve Jerome Powell’s With his semi-annual speech to the Senate Banking Committee fresh in our minds this week, now is an ideal time to think about the drivers of r*.In response to Subsequent changes in the financial environment Impact Regarding financial situation.

The force that drives R*

R* is widely believed to be determined by real forces that structurally affect the balance of savings and investment in the economy, including potential economic growth, demographics, risk aversion, fiscal policy, etc. It is the rate that prevails in equilibrium after the effects of short-term disturbances have subsided.

All of this makes r* unobservable, and analysts and economists must rely on models to approximate the rate. Each model has strengths and weaknesses, and the resulting estimated rate is model-dependent and not the true r*.

Central banks regularly estimate the natural rate using different models. The Federal Reserve Bank of New York estimates the natural rate using: for example(2016) use the Laubach-Williams (LW) and Holston-Laubach-Williams (HLW) models, the latter of which is shown in Figure 1 .

Appendix 1.

The elusive neutral interest rate picture 1

Source: Federal Reserve Bank of New York.

Is money truly neutral?

Despite the challenges associated with relying on different models to derive r*, there was a clear trend that each model shared: a secular decline in interest rates over a 40-year period. This decline was driven by structural factors that pushed interest rates even lower. Factors such as rising Chinese savings rates and strong demand for U.S. securities, higher savings and lower investment due to an aging population, globalization, and slow productivity growth contributed to the decline in the neutral interest rate.

But there is another factor that influences r* that is less discussed: monetary policy. Most macroeconomic studies assume that money is neutral and does not affect real variables, and that r* is determined by the real variables. So, in theory, monetary policy is irrelevant in the search for r*. But in practice, monetary policy is not irrelevant.

The importance of monetary policy is clear when we consider the decades-long efforts of major central banks to slash interest rates, and indeed to push them far below r*. When this happens, several “evil” forces take hold in the economy, and these evils affect both real and nominal variables, Edward Chancellor explains in his book. The Price of Time: The Real Story of Interest.

One drawback is mis-valuation of investments: artificially low interest rates lower the threshold for valuing projects, which in turn directs funds to sectors and projects with lower than normal expected returns.

The other is the “zombie” economy: when interest rates are low and debt financing is plentiful, companies that would otherwise go bankrupt continue to operate with ever-higher debt loads. Schumpeter’s mechanism Creative destruction will be halted and unviable companies will continue to exist.

Third, supply chains are becoming longer. Low interest rates encourage unsustainable expansion of supply chains as manufacturers push production steps further into the future. This means that rising interest rates will reverse the trend towards globalization, as we are already beginning to see.

The fourth evil is fiscal imprudence. It is tempting for politicians to pump money into popular policies to win elections. When interest rates are low and bond “vigilantes” are nowhere to be found, the temptation is impossible to avoid. This is reflected in the fact that the US budget balance is always in deficit. The fact that the US budget deficit is 6% of GDP is a worrying trend for the United States.

Figure 2. Federal surplus or deficit as a percentage of GDP.

Image 2 The elusive neutral interest rate 2

Source: Federal Reserve Bank of St. Louis.

Staying consistently below r* not only leads to higher inflation but also creates various imbalances across the economy that will need to be corrected at some point, with considerable pain and impact on real variables.

The fact is that monetary policy has not been neutral and central banks have not pursued the equilibrium interest rate, but rather have driven it lower and lower on the assumption that this is the way to achieve maximum employment, regardless of the imbalances building up in the economy as a whole.

Where do we go from here?

Finding the future trajectory of the neutral rate requires forecasting how structural factors in the economy will behave, some of which are clear, while others may or may not materialize.

First, post-pandemic inflation has forced central banks to end the era of ultra-low interest rates, and the market consensus is that we will not return to a near-zero interest rate environment in the near term.

Second, large budget deficits are far from being fixed. The US has no fiscal consolidation plan. Outside the US, public spending is expected to increase further, driven by three main factors: aging, greening, and increased defense spending.

Third, financial globalization will be pushed back by rising interest rates and geopolitical fragmentation.

On the bright side, or in terms of investment, it remains to be seen whether artificial intelligence (AI) and green technology will live up to expectations and attract private investment.

Taken together, these factors suggest a rise in r* and an end to the secular decline in interest rates.

Will we find R*?

Estimating r* is a difficult task. After all, there is no single r* that can be estimated. In the European Union (EU), the natural rate of interest differs from the r* recognized in member states Spain and Finland, for example, but the European Central Bank (ECB) currently sets a single interest rate that applies across the EU.

Research will likely produce more sophisticated models, but in an era defined by all-powerful central banks, r* may in fact be an artificial construct: interest rates reflect bureaucratic decisions rather than private decisions of individuals.

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