Wednesday, October 14, 2015

Natural Rate of interest - what you always wanted to know but were afraid to ask

Really. This is relevant.  And interesting because it says monetary policy is tight and Janet Yellen says it is accommodative.

I am not endorsing this.  Estimating, and that is their word, is inexact and they use a wide band of interest rate then decide on the middle of it as the figure.

Real means inflation adjusted.  Just to be clear.
Core personal consumption expenditures price index (Core PCE).  This is the favored inflation gauge of the Fed.

Fed Funds rate.  This is the focus of it all.  It is the one rate the Fed can affect and it drives all other interest rates.

The natural rate of interest is the real fed funds rate that we should be at to have the economy operating at full employment with stable prices.  Right now, the economy is operating at very close to full employment and very close to stable prices.  “Full employment” definitely is anemic when looking various other data besides the unemployment rate so there can be improvement there.

Right now the experts think that the natural rate of interest is at -2.1%.  And the problem is that real fed funds rate is at -1.17% (Fed Funds rate .13% minus core PCE inflation 1.3%).

The theory is that if real fed funds rate is above the natural rate of interest it is contractional.  If the fed funds rate is below the natural rate of interest it is stimulative.  Therefore right now, monetary policy is actually tight, given the circumstances of the economy.

How do they determine the -2.1% natural rate of interest?  They start with what they believe, based on the structure of the economy and history, what potential GDP is.  Then they see what GDP actually is.  Using a scale derived from economic history, they determine what the natural rate of interest is at any given level of actual GDP relative to potential GDP.

The natural rate of interest historically has been +3.0%.  Again, the natural rate of interest is the real fed funds rate at which the economy is operating at full employment and stable prices.

If the Fed were to reduce the real fed funds rate to -2.1%, it is felt that actual full employment would be reached all the while prices remain stable.

Now you just figured out that is a problem because nobody is happy with the economy and it is operating below potential.  The fed wants 2% stable inflation, not 1.3%.  Everyone wants labor to make more money but not enough to destabilize inflation in an upward manner.

Nothing in this concept does anything for getting GDP back to its potential.  In fact, the experts themselves say that the natural rate of interest is unobservable.

The Natural Rate of Interest can go up and it can go down.  But it is changes in supply and demand that make the economy go up and down relative to its potential and the natural rate of interest will rise and fall with it.

You know, this sounds so good I might come round to thinking we should try it.  Try -2.1% real fed funds rates and get the economy operating at its potential given the current status of supply and demand.

Negative interest rates.  What could go wrong?  It sure would make the stock market rocket.

Maybe someday someone will think of some things to increase supply and demand.  But that is then, and this is now.

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