Introduction
The natural rate of interest is a central concept that helps us understand macroeconomic relationships and the effects of monetary policy. Also known as the long-run equilibrium interest or simply R-star, it represents the interest rate that exists when the economy is at full employment and stable inflation. This rate indicates when monetary policy is neither restrictive nor expansionary, it has to be high enough to stimulate saving while remaining quite low to encourage borrowing. It is typically discussed in real terms, so inflation is subtracted from the nominal rate. The Fed does not determine R-star, and it cannot be directly observed but must be estimated. Interest rates above the natural rate slow economic and price growth, while rates below stimulate economic activity. For example, the Fed may temporarily set the benchmark of the federal funds rate, at which banks borrow from each other overnight, above the neutral rate to cool the economy. So, what's important isn't the actual level of the natural rate but its relation with other interest rates. Essentially, some argue that the inflation-adjusted natural rate serves as a reference point for monetary policy.
Why is it elusive? Different perspectives
The neutral rate’s level is a subject of continuous debate. There is no universal agreement on a single model for its current value and future projections, partly due to its dependence on various factors like GDP growth, demographics, and other variables that evolve with time. This disagreement leads central bankers to approach it carefully. Bert Colijn, a senior economist at ING bank, acknowledges its usefulness in assessing past economic performance. However, he warns against using it as the unique basis for future policy decisions, highlighting its constant volatility.
On the one hand, some economists suggest that the R-star has risen. Megan Greene, an external member of the Bank of England's Monetary Policy Committee, argues that the neutral rate might have increased due to the growing public debt and investments in green transitions. At the same time, Raphael Bostic, president of the Atlanta Fed, believes that the neutral rate has likely increased to between 2.5% and 3%, including 2% of inflation.
Additionally, some sophisticated estimates of real R-star suggest a significant increment, up to 2.23% by October 2023. Economists Thomas Lubik of the Richmond Fed and Christian Matthes of Indiana University have built such an estimation: the Lubik-Matthes Natural Rate of Interest. Other economists have developed different empirical methods to obtain the natural rate from real-world data. For Lubik and Matthes the problem of such models lies in the natural interest hypothetical nature that cannot be measured directly. So, their approach applies fewer theoretical restrictions and a more adaptable economic framework than other models like the Laubach-Williams and Holston-Laubach-Williams models from the Federal Reserve Bank of New York.
On the other hand, John Williams, president of the New York Federal Reserve, alongside Kathryn Holston and the late Thomas Laubach, claims that despite recent shocks, the global economy may not have transformed as much as perceived. According to their research and model, the pandemic and other events didn't really change the era of low inflation and interest rates. Their estimates show that R-star barely changed, meaning inflation and rates might return to pre-shock levels.
This perspective aligns with the IMF's World Economic Outlook and Bank of Finland Governor Olli Rehn's views, which anticipate a return to pre-pandemic interest rate levels. It’s also reflected in the Federal Reserve’s median long-run fed funds rate projection, which was 2.5 per cent in June: 2 per cent inflation and a 0.5 per cent long-run neutral rate.
However, econometrics estimates and modelling for R-star are highly challenging and characterized by imprecision and real-time measurement errors.
Furthermore, The uncertainty about R-star is composed of several estimation methods and fundamental uncertainties regarding its economic significance and drivers. Jeremy Stein, a Harvard professor and former Fed governor, in a recent lecture at the US Monetary Policy Forum (March 1, 2024), emphasizes the imperfections of numerical estimates of R-star, highlighting the wide confidence intervals and inconsistencies in model predictions.
Finally, while R-star remains a concept of interest for economists and policymakers, its numerical calculations should be considered with caution. Central banks should keep evaluating the effectiveness of short-term monetary policies using diverse measures, avoiding extreme reliance on R-star valuation derived from a single model.
What are the dangers of a low neutral rate?
Neutral rates have decreased in recent decades due to several long-term factors: slow productivity growth, a surplus of global savings, and an ageing population that has increased retirement savings.
A low neutral rate limits the Fed's ability to lower interest rates during recessions, opening the problem of the zero lower bound and the liquidity trap. With inflation at 2% and a 1% neutral real rate, nominal rates would be around 3%, leaving little room for cuts before hitting zero. Research suggests that in cases of a very low neutral rate, rates may hit zero in up to 40% of recessions. Distinct proposals, such as unconventional monetary policy and adjustments to the Fed's rules, aim to address these zero-lower-bound problems. But since the neutral rate stays low, the Fed must keep finding innovative and complex monetary policy solutions.
Following these reflections, the question at the heart of this article is whether a nominal neutral rate of 5% can be sustainable for the American economy in the long run. This begins with a historical analysis of the neutral rate's trends, then moves to an examination of the current situation, and concludes by assessing the potential sustainability of a higher neutral rate compared to that provided by recent economic estimates.
Historical analysis of neutral rate’s trend
The neutral (often referred to as natural) rate of interest R* is the real interest rate that neither stimulates nor contracts the economy and is consistent with output at potential and stable inflation.It is not an observable digit and so it needs to be estimated.Knowing R* is very important for central banks all over the world because based on it, they can assess if policy rates are going to slow or to boost the economy and inflation.Although affected by high uncertainty, studies show a decreasing trend in the neutral rate in most advanced economies. In this analysis we will focus on the United States.
The graph above shows the estimates for R* using the Holston-Laubach-Williams model. As pointed out, it has plummeted by almost 400 base points since the 1960s, and has registered a dramatic drop during the GFC, reaching a low level at 0,5%.This situation is not good for monetary policy: after the GFC central banks have lowered interest rates touching 0% or getting even negative in the euro area. Despite that, the decade between GFC and the covid pandemic has been marked by low inflation and fear of deflation.
This scenario suggests that during this period R* was low as suggested, limiting CBs capability to respond to demand shocks. Because of that, central banks couldn’t lower policy rates (nominal rates cannot fall below 0) as much as they needed to rapidly recover the economy and so they were forced to adopt unconventional monetary policy tools such as quantitative easing. Low R* has also been pointed out as a possible driver of the so-called secular stagnation by experts.Due to the importance of R* it is necessary to understand what main factors are influencing it.
According to the IMF's April 2023 economic outlook, the most important is growth but there are also other dynamics. We can divide those drivers in macroeconomic and financial.Generally R* decreases because of growth in savings or decline in investments.
- Productivity growth enhances the opportunity cost of savings so that the lender requires higher interest rates from the borrower.
- Demographics: literature suggests various factors that affect the R*; Baby boom generation habits in savings and investment could influence the neutral rate. Also, there’s an argument about increased longevity according to which, people save more expecting a longer retirement period.
- Fiscal policy, through more government borrowing, increases investment demand and so the interest rate. However, this effect is ambiguous because of the amount of investment displaced by public debt.
- Other factors: the rise in corporate market power could lower redistribution of income to labour and reduce savings. A push in the other direction is given by the rise in income inequality that increases savings because high-income people save more.
On financial side we have forces that push R* in different direction:
- Ongoing financial integration between advanced economies and high-growth emerging markets provides investments opportunities that push R* upwards.
- Primarily in times of deleveraging, safe and liquid assets face a higher demand. This is true for advanced economies, especially the US where the safety of the dollar, makes US treasury desirable enhancing their value and changing down their return.
Focusing on the period from 2007 to 2018 and following the analysis made by Obstfeld (2023), we reach the conclusion that this period is distinguished by recovery from crisis and private risk aversion that make the demand for safe assets higher. Also, during this period safe asset supplies grow more slowly or shrink driving up prices and lowering returns.
Here is a graph illustrating the role played by main drivers in 5 advanced economies and 3 EMEs using the macroeconomic model based on Platzer and Peruffo (2022).
The largest net negative effect is found in the United States, probably due to the demand of safe assets by emerging markets that dominate the rising effect deriving from high return opportunities abroad.
According to a study was prepared for the 2021 Jackson Hole Economic Symposium, before the GFC on average 77% of the decline in R* was caused by changes in the residual component (shift in household preferences).
After 2008, the lower long-term growth rate makes up an increasingly larger share of the changes, although the contributions of the residual component still average 64% in the post-crisis period.So it highlights slowing global growth as one force that may have pushed down real rates recently, but shifts in saving and investment preferences appear more important in explaining the long-term decline.
Analysis of the current situation
The neutral rate is a current theme in the US, which is increasingly gaining ground as macroeconomic data becomes complicated to analyze together. The neutral rate is not only subject to discussion among FED officials, but also among citizens. The graph below (source: Google Trends) measures the interest of the research on Google; when the value of the index is 0 means that the selected words have been searched with very low frequency in the selected time span, while when the value is 100 it means that the selected words have been searched frequently. The chart shows how the interest in "Neutral rate" and "What is neutral rate" research in the US has increased significantly in the last three years.
Given the popularity of the topic and the importance for policymakers, it is crucial to analyze the actual situation in the US in order to understand if a neutral rate of 2% given an inflation rate of 3% and a nominal rate of 5% is sustainable in the long run for the US economy.
In the long run, the neutral rate of interest is determined by the supply of and demand for savings. For example, for firms to make new investments, they need households and other savers to supply the capital to finance that investment. Therefore, total investment in the economy must be equal to the pool of available capital or savings. This is nothing else that the IS-LM model, as perfectly explained by Paul Krugman in its article “IS-LMentary” published in The New York Times in October 2011. He explained how GDP must be taken into account: a higher level of GDP will mean more transactions, and hence higher demand for money, other things equal. So higher GDP will mean that the interest rate needed to match supply and demand for money must rise. Hence, in order to correctly estimate the neutral rate, it is important that there is no, or, at least, negligible output gap in the GDP estimates.
Let’s look at the actual neutral interest rate in the US, estimated with the Laubach-Williams and Holston-Laubach-Williams models (Federal Reserve Bank of New York, Measuring the Natural Rate of Interest).
The Laubach-Williams give us an estimated neutral rate of 1.12% for Q4 2023, while the Holston-Laubach-Williams estimation for Q4 2023 is 0.74%.
It is interesting to note how in both charts there is a divergence between trend growth and R-Star after the Covid peak; after the peak the R-star is decreasing, while the trend growth is increasing. This is a first signal that the estimates of the neutral rate could be too much lower than what the actual US economy needs.
A second signal comes from US output gap data. If what Paul Kraugman said in his article cited above is true, then there should be a low delta between real GDP and potential GDP, i.e. the output gap should be low otherwise the estimated IS-LM equilibrium requires a higher interest rate.
The graph below, taken from the FRED site, measures the percentage difference between the two variables. Interestingly, this difference, while small, has been growing since Q2 2022. This should be a wake-up call, as analysts have been underestimating GDP growth for almost two years; an underestimation of GDP could lead to an underestimation of the neutral interest rate, which could therefore actually be higher than estimated by the LW and HLW models previously observed.
There is also a third signal about the underestimation of the neutral interest rate; the US policy mix. In his 2023 Jackson Hole speech, Jerome Powell stressed that rather than relying heavily on estimates of the natural rate to conduct monetary policy, the Fed should adopt a risk management approach by “balancing the risk of tightening monetary policy too much against the risk of tightening too little.”These words are even more important if, together with a restrictive monetary policy, there is, on the contrary, an expansionary fiscal policy; while FED is reducing its balance sheet with QT, the US government is injecting fresh money in the economy, increasing reserves. We are facing a situation in which, even if there is QT, the overall liquidity is not decreasing in general and this contradiction is supporting the resilience of the US economy even when faced with nominal rates above 5%. In the chart below, building on Tradingview, is representing the total assets in the FED’s balance sheet in blue and the total reserves of depository institutions in orange.
These three inputs (divergence between R-Star and trend growth, positive and increasing output gap and mix of monetary and fiscal policies) give us a clear output: we are facing a macroeconomic phase that is probably never experienced in the past. In this new macroeconomic phase we have sticky inflation around 3%, therefore closer to the FED’s target rather than the 2022 peak and a labor market that since the end of 2021 to date has created less than 200,000 jobs compared to the previous month on only three occasions. At the same time, consumption remains robust and continues to weigh around 70% of GDP.
The actual situation, given what we stated above, suggests that a nominal rate of ~ 5% is sustainable for the US and at the moment it seems that it can be the optimal rate for the so-called “Steady State”, but will it be sustainable in the long run?
Is a nominal rate of 5% sustainable?
An interest rate of 5.5% may not be sustainable in the long term, depending on the economic and financial conditions of a country or economic region. A rate of 5.5% could be considered high for many advanced economies, where thel rate is usually lower, around 2-3%. A higher interest rate can slow down economic activity, particularly if it surpasses expected growth and inflation rates.
Numerous sources speak of a truly new phase for the American economy; with the economy not entering a recession but rather undergoing a process called "soft landing," and with "stable" inflation that does not require strong efforts to reduce, there could be a genuine phase where interest rates are neither cut nor increased. However, if the U.S. public debt needs to be financed by new investors, adjustments to rates will be necessary, which would bring about changes within the economic balances.
To verify if a nominal rate of 5.5% is sustainable, it is necessary to consider several factors, including:
● Current and projected economic growth.
● Current and projected inflation.
● Ongoing monetary policies.
● Stability of the financial system.
If the nominal rate of 5.5% is significantly higher than the growth and inflation rate, it could have a restrictive impact on the economy, slowing down growth and increasing the cost of credit. In such a case, a lower neutral rate might be necessary to maintain the economy in balance.
In summary, the sustainability of a nominall rate of 5.5% depends on the specific economic conditions and market factors.
1) Current and projected economic growth:
According to the data, there has been a slowdown in GDP growth, as the result of 1.6% is significantly lower than the expected 2.4%, particularly in the last quarter of 2023, when there was growth of 3.4%. In any case, this growth was supported by increased consumer spending, which grew by 2.5% and represents a little over two-thirds of the U.S. economy.
The reason behind this "slowdown" might be that the last quarter was a significant surprise, as it was the decisive quarter that disproved market analysts' studies, which at the beginning of the year expected GDP growth of 1.9% rather than the 2.4% seen in 2023.
Therefore, the 5% rate managed to prevent the U.S. economy from entering a recessionary phase. Regarding the future, it should be noted that 2024 is an election year, and the geopolitical scenario is not particularly comforting, both in Europe and in the Middle East; these reasons lead analysts to remain cautious rather than overly optimistic.
2) Current and projected inflation:
In March 2024, there was a slight increase in inflation, but this will not change expectations that the Fed will not cut interest rates until September; the U.S. PCE data showed a +0.3% increase in March as well.
This certainty that this data is not enough to cut rates comes directly from the words of Jerome Powell, the president of the Federal Reserve, who stated that the future requires other good data like those seen in the second half of 2023, so the American central bank prefers to be careful and cautious because the labor market is very solid according to the data. Powell's goal is to find the right timing for rate cuts, as doing it too soon would increase inflation, while doing it too late would obviously harm the economy.
3) Ongoing monetary policies.
As for monetary policy in the USA, the most significant aspect is undoubtedly that of wages; the labor market is in constant and sustained growth thanks to a generous fiscal policy and structural conditions that go beyond the Fed's intervention. In March 2024, there was an increase of 300,000 jobs in non-agricultural sectors, while the estimate was just over 200,000. The unemployment rate fell by another 0.1 percentage points from 3.9% to 3.8%.
We can therefore easily say that the levels have returned to pre-pandemic levels, with the difference that this recent period has seen a significant increase in wages because, after COVID-19, workers have taken a stronger position within the economic context. It is worth noting, however, that today we are experiencing slower growth compared to a few months ago but still faster than before the pandemic.
It can be said that we have now reached a more normalized context, as after the coronavirus, the balance between wages and unemployment was lost, with the former even being able to slow down (a concept called market slack) without the unemployment rate increasing. This is also why Powell decided not to intervene but to wait.
4) Stability of the financial system.
In March 2024, the Fed sounded an alarm by announcing that there are many vulnerabilities in financial markets, while the banking market is experiencing less stress due to the central bankers' focus on leverage, which also increases the risks in the financial sector.
Another element that could pose challenges is the levels of stock prices, which raise concerns not only in absolute terms but especially because it's important to remember that the U.S. market is highly debt-centered due to the Fed's previously low rates. This has led Powell to remain cautious about cutting rates in the immediate term.
Regarding the banking market, it is important to mention that it is tied to an additional fee program for institutions to ensure greater stability. This comes after the collapse of NY Community Bancorp due to non-compliance with rating thresholds in the granting of loans.
Conclusions
In concluding this essay on the neutral rate of interest, it's vital to acknowledge its complexity and the challenges it presents to economists and policymakers. The concept of R-star is a fundamental element of macroeconomic theory, indicating the rate at which the economy operates at full capacity (full employment) without accelerating inflation.
Despite its central role, determining the exact level of R-star proves elusive, due to uncertainty because of changing economic conditions and the influence of various factors like demographics, productivity growth, and global capital flows. Central banks, such as the Federal Reserve, use estimates of the neutral rate to guide their interest rate decisions, which in turn affect everything from consumer borrowing costs to business investments. Some experts believe that R-star has increased due to factors such as growing public debt and investments in green initiatives.
In contrast, others, noting the stability during recent economic shocks, argue that changes in the global economy might not have significantly altered the rate. Sophisticated models, such as those by Lubik-Matthes and Laubach-Williams, attempt to estimate R-star with varying degrees of theoretical restrictions and adaptability, but all face challenges due to the inherent uncertainties and the rate's sensitivity to immediate economic conditions.
Moreover, the low neutral rate has been linked to long-term economic trends like slow productivity growth, high global savings rates, and demographic changes, which limit the Fed's ability to adjust interest rates effectively during recessions, potentially leading to liquidity traps. This situation necessitates the use of unconventional monetary policies and underscores the critical importance of continuously adapting our understanding and methodologies for estimating R-star to ensure robust and effective monetary policy.
Public and expert interest in this topic has grown significantly, as shown by Google Trends data. Models like those from Laubach-Williams and Holston-Laubach-Williams currently suggest a lower neutral rate than might be needed given the actual economic activity and growth trends, particularly after COVID. The gap between these estimates and real economic indicators, such as GDP growth and the gap between actual and potential GDP, suggests that the neutral rate might be underestimated. Jerome Powell's emphasis on using a careful approach to adjust monetary policy highlights the complexity of achieving economic stability. In summary, while a 5% nominal rate seems to work for now, it's essential to keep evaluating this rate to ensure it remains suitable as economic conditions change, potentially pointing to a need to raise the neutral rate.
To determine whether a nominal interest rate of 5.5%, high for the majority of advanced economies, is sustainable for the long term in the U.S., several crucial factors must be considered. These include current and projected economic growth, inflation, ongoing monetary policies, and the overall stability of the financial system.
Recent data indicates a slowdown in GDP growth and only slight increases in inflation, suggesting that immediate increases in rates might not be necessary. However, the solid labor market performance and the increase in wages post-pandemic provide some buffer against economic slowdown. Moreover, the stability of the financial system, marked by vulnerabilities in financial markets and a cautious approach by the Federal Reserve to not adjust rates rapidly, plays a crucial role. These elements highlight the delicate balance required in monetary policy to balance between stimulating economic growth and controlling inflation without triggering financial instability.
Given these dynamics, maintaining a nominal rate of 5% poses challenges and risks. While it might currently stabilize economic conditions and deter recession, it's crucial for policymakers to remain adaptive.
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