Archive for the 'natural rate of unemployment' Category

Who Sets the Real Rate of Interest?

Understanding economics requires, among other things, understanding the distinction between real and nominal variables. Confusion between real and nominal variables is pervasive, constantly presenting barriers to clear thinking, and snares and delusions for the mentally lazy. In this post, I want to talk about the distinction between the real rate of interest and the nominal rate of interest. That distinction has been recognized for at least a couple of centuries, Henry Thornton having mentioned it early in the nineteenth century. But the importance of the distinction wasn’t really fully understood until Irving Fisher made the distinction between the real and nominal rates of interest a key element of his theory of interest and his theory of money, expressing the relationship in algebraic form — what we now call the Fisher equation. Notation varies, but the Fisher equation can be written more or less as follows:

i = r + dP/dt,

where i is the nominal rate, r is the real rate, and dP/dt is the rate of inflation. It is important to bear in mind that the Fisher equation can be understood in two very different ways. It can either represent an ex ante relationship, with dP/dt referring to expected inflation, or it can represent an ex post relationship, with dP/dt referring to actual inflation.

What I want to discuss in this post is the tacit assumption that usually underlies our understanding, and our application, of the ex ante version of the Fisher equation. There are three distinct variables in the Fisher equation: the real and the nominal rates of interest and the rate of inflation. If we think of the Fisher equation as an ex post relationship, it holds identically, because the unobservable ex post real rate is defined as the difference between the nominal rate and the inflation rate. The ex post, or the realized, real rate has no independent existence; it is merely a semantic convention. But if we consider the more interesting interpretation of the Fisher equation as an ex ante relationship, the real interest rate, though still unobservable, is not just a semantic convention. It becomes the theoretically fundamental interest rate of capital theory — the market rate of intertemporal exchange, reflecting, as Fisher masterfully explained in his canonical renderings of the theory of capital and interest, the “fundamental” forces of time preference and the productivity of capital. Because it is determined by economic “fundamentals,” economists of a certain mindset naturally assume that the real interest rate is independent of monetary forces, except insofar as monetary factors are incorporated in inflation expectations. But if money is neutral, at least in the long run, then the real rate has to be independent of monetary factors, at least in the long run. So in most expositions of the Fisher equation, it is tacitly assumed that the real rate can be treated as a parameter determined, outside the model, by the “fundamentals.” With r determined exogenously, fluctuations in i are correlated with, and reflect, changes in expected inflation.

Now there’s an obvious problem with the Fisher equation, which is that in many, if not most, monetary models, going back to Thornton and Wicksell in the nineteenth century, and to Hawtrey and Keynes in the twentieth, and in today’s modern New Keynesian models, it is precisely by way of changes in its lending rate to the banking system that the central bank controls the rate of inflation. And in this framework, the nominal interest rate is negatively correlated with inflation, not positively correlated, as implied by the usual understanding of the Fisher equation. Raising the nominal interest rate reduces inflation, and reducing the nominal interest rate raises inflation. The conventional resolution of this anomaly is that the change in the nominal interest rate is just temporary, so that, after the economy adjusts to the policy of the central bank, the nominal interest rate also adjusts to a level consistent with the exogenous real rate and to the rate of inflation implied by the policy of the central bank. The Fisher equation is thus an equilibrium relationship, while central-bank policy operates by creating a short-term disequilibrium. But the short-term disequilibrium imposed by the central bank cannot be sustained, because the economy inevitably begins an adjustment process that restores the equilibrium real interest rate, a rate determined by fundamental forces that eventually override any nominal interest rate set by the central bank if that rate is inconsistent with the equilibrium real interest rate and the expected rate of inflation.

It was just this analogy between the powerlessness of the central bank to hold the nominal interest rate below the sum of the exogenously determined equilibrium real rate and the expected rate of inflation that led Milton Friedman to the idea of a “natural rate of unemployment” when he argued that monetary policy could not keep the unemployment rate below the “natural rate ground out by the Walrasian system of general equilibrium equations.” Having been used by Wicksell as a synonym for the Fisherian equilibrium real rate, the term “natural rate” was undoubtedly adopted by Friedman, because monetarily induced deviations between the actual rate of unemployment and the natural rate of unemployment set in motion an adjustment process that restores unemployment to its “natural” level, just as any deviation between the nominal interest rate and the sum of the equilibrium real rate and expected inflation triggers an adjustment process that restores equality between the nominal rate and the sum of the equilibrium real rate and expected inflation.

So, if the ability of the central bank to use its power over the nominal rate to control the real rate of interest is as limited as the conventional interpretation of the Fisher equation suggests, here’s my question: When critics of monetary stimulus accuse the Fed of rigging interest rates, using the Fed’s power to keep interest rates “artificially low,” taking bread out of the mouths of widows, orphans and millionaires, what exactly are they talking about? The Fed has no legal power to set interest rates; it can only announce what interest rate it will lend at, and it can buy and sell assets in the market. It has an advantage because it can create the money with which to buy assets. But if you believe that the Fed cannot reduce the rate of unemployment below the “natural rate of unemployment” by printing money, why would you believe that the Fed can reduce the real rate of interest below the “natural rate of interest” by printing money? Martin Feldstein and the Wall Street Journal believe that the Fed is unable to do one, but perfectly able to do the other. Sorry, but I just don’t get it.

Look at the accompanying chart. It tracks the three variables in the Fisher equation (the nominal interest rate, the real interest rate, and expected inflation) from October 1, 2007 to July 2, 2013. To measure the nominal interest rate, I use the yield on 10-year Treasury bonds; to measure the real interest rate, I use the yield on 10-year TIPS; to measure expected inflation, I use the 10-year breakeven TIPS spread. The yield on the 10-year TIPS is an imperfect measure of the real rate, and the 10-year TIPS spread is an imperfect measure of inflation expectations, especially during financial crises, when the rates on TIPS are distorted by illiquidity in the TIPS market. Those aren’t the only problems with identifying the TIPS yield with the real rate and the TIPS spread with inflation expectations, but those variables usually do provide a decent approximation of what is happening to real rates and to inflation expectations over time.

real_and_nominal_interest_rates

Before getting to the main point, I want to make a couple of preliminary observations about the behavior of the real rate over time. First, notice that the real rate declined steadily, with a few small blips, from October 2007 to March 2008, when the Fed was reducing the Fed Funds target rate from 4.75 to 3% as the economy was sliding into a recession that officially began in December 2007. The Fed reduced the Fed Funds target to 2% at the end of April, but real interest rates had already started climbing in early March, so the failure of the FOMC to reduce the Fed Funds target again till October 2008, three weeks after the onset of the financial crisis, clearly meant that there was at least a passive tightening of monetary policy throughout the second and third quarters, helping create the conditions that precipitated the crisis in September. The rapid reduction in the Fed Funds target from 2% in October to 0.25% in December 2008 brought real interest rates down, but, despite the low Fed Funds rate, a lack of liquidity caused a severe tightening of monetary conditions in early 2009, forcing real interest rates to rise sharply until the Fed announced its first QE program in March 2009.

I won’t go into more detail about ups and downs in the real rate since March 2009. Let’s just focus on the overall trend. From that time forward, what we see is a steady decline in real interest rates from over 2% at the start of the initial QE program till real rates bottomed out in early 2012 at just over -1%. So, over a period of three years, there was a steady 3% decline in real interest rates. This was no temporary phenomenon; it was a sustained trend. I have yet to hear anyone explain how the Fed could have single-handedly produced a steady downward trend in real interest rates by way of monetary expansion over a period of three years. To claim that decline in real interest rates was caused by monetary expansion on the part of the Fed flatly contradicts everything that we think we know about the determination of real interest rates. Maybe what we think we know is all wrong. But if it is, people who blame the Fed for a three-year decline in real interest rates that few reputable economists – and certainly no economists that Fed critics pay any attention to — ever thought was achievable by monetary policy ought to provide an explanation for how the Fed suddenly got new and unimagined powers to determine real interest rates. Until they come forward with such an explanation, Fed critics have a major credibility problem.

So please – pleaseWall Street Journal editorial page, Martin Feldstein, John Taylor, et al., enlighten us. We’re waiting.

PS Of course, there is a perfectly obvious explanation for the three-year long decline in real interest rates, but not one very attractive to critics of QE. Either the equilibrium real interest rate has been falling since 2009, or the equilibrium real interest rate fell before 2009, but nominal rates adjusted slowly to the reduced real rate. The real interest rate might have adjusted more rapidly to the reduced equilibrium rate, but that would have required expected inflation to have risen. What that means is that sometimes it is the real interest rate, not, as is usually assumed, the nominal rate, that adjusts to the expected rate of inflation. My next post will discuss that alternative understanding of the implicit dynamics of the Fisher equation.

Why Are Real Interest Rates So Low, and Will They Ever Bounce Back?

In his recent post commenting on the op-ed piece in the Wall Street Journal by Michael Woodford and Frederic Mishkin on nominal GDP level targeting (hereinafter NGDPLT), Scott Sumner made the following observation.

I would add that Woodford’s preferred interest rate policy instrument is also obsolete.  In the next recession, and probably the one after that, interest rates will again fall to zero.  Indeed the only real suspense is whether they’ll be able to rise significantly above zero before the next recession hits.  In the US in 1937, Japan in 2001, and the eurozone in 2011, rates had barely nudged above zero before the next recession hit. Ryan Avent has an excellent post discussing this issue.

Perhaps I am misinterpreting him, but Scott seems to think that the decline in real interest rates reflects some fundamental change in the economy since approximately the start of the 21st century. Current low real rates, below zero on US Treasuries well up the yield curve. The real rate is unobservable, but it is related to (but not identical with) the yield on TIPS which are now negative up to 10-year maturities. The fall in real rates partly reflects the cyclical tendency for the expected rate of return on new investment to fall in recessions, but real interest rates were falling even before the downturn started in 2007.

In this post, at any rate, Scott doesn’t explain why the real rate of return on investment is falling. In the General Theory, Keynes speculated about the possibility that after the great industrialization of the 19th and early 20th centuries, new opportunities for investment were becoming exhausted. Alvin Hansen, an early American convert to Keynesianism, developed this idea into what he called the secular-stagnation hypothesis, a hypothesis suggesting that, after World War II, even with very low interest rates, the US economy was likely to relapse into depression. The postwar boom seemed to disprove Hansen’s idea, which became a kind of historical curiosity, if not an embarrassment. I wonder if Scott thinks that Keynes and Hansen were just about a half-century ahead of their time, or does he have some other reason in mind for why he thinks that real interest rates are destined to be very low?

One possibility, which, in a sense, is the optimistic take on our current predicament, is that low real interest rates are the result of bad monetary policy, the obstacle to an economic expansion that, in the usual course of events, would raise real interest rates back to more “normal” levels. There are two problems with this interpretation. First, the decline in real interest rates began in the last decade well before the 2007-09 downturn. Second, why does Scott, evidently accepting Ryan Avent’s pessimistic assessment of the life-expectancy of the current recovery notwithstanding rapidly increasing support for NGDPLT, anticipate a relapse into recession before the recovery raises real interest rates above their current near-zero levels? Whatever the explanation, I look forward to hearing more from Scott about all this.

But in the meantime, here are some thoughts of my own about our low real interest rates.

First, it can’t be emphasized too strongly that low real interest rates are not caused by Fed “intervention” in the market. The Fed can buy up all the Treasuries it wants to, but doing so could not force down interest rates if those low interest rates were inconsistent with expected rates of return on investment and the marginal rate of time preference of households. Despite low real interest rates, consumers are not rushing to borrow money at low rates to increase present consumption, nor are businesses rushing to take advantage of low real interest rates to undertake shiny new investment projects. Current low interest rates are a reflection of the expectations of the public about their opportunities for trade-offs between current and future consumption and between current and future production and their expectations about future price levels and interest rates. It is not the Fed that is punishing savers, as the editorial page of the Wall Street Journal constantly alleges. Rather, it is the distilled wisdom of market participants that is determining how much any individual should be rewarded for the act of abstaining from current consumption. Unfortunately, there is so little demand for resources to be used to increase future output, the act of abstaining from current consumption contributes essentially nothing, at the margin, to the increase of future output, which is why the market is now offering next to no reward for a marginal abstention from current consumption.

Second, interest rates reflect the expectations of businesses and investors about the profitability of investing in new capital, and the expectations of households about their future incomes (largely dependent on expectations about future employment). These expectations – about profitability and about future incomes — are distinct, but they are clearly interdependent. If businesses are optimistic about the profitability of future investment, households are likely to be optimistic about future incomes. If households are pessimistic about future incomes, businesses are unlikely to expect investments in new capital to be profitable. If real interest rates are stuck at zero, it suggests that businesses and households are stuck in a mutually reinforcing cycle of pessimistic expectations — households about future income and employment and businesses about the profitability of investing in new capital. Expectations, as I have said before, are fundamental. Low interest rates and secular stagnation need not be the result of an inevitable drying up of investment opportunities; they may be the result of a vicious cycle of mutually reinforcing pessimism by households and businesses.

The simple Keynesian model — at least the Keynesian-cross version of intro textbooks or even the IS-LM version of intermediate textbooks – generally holds expectations constant. But in fact, it is through the adjustment of expectations that full-employment equilibrium is reached. For fiscal or monetary policy to work, they must alter expectations. Conventional calculations of spending or tax multipliers, which implicitly hold expectations constant, miss the point, which is to alter expectations.

Similarly, as I have tried to suggest in my previous two posts, what Friedman called the natural rate of unemployment may itself depend on expectations. A change in monetary policy may alter expectations in a manner that reduces the natural rate. A straightforward application of the natural-rate model leads some to dismiss a reduction in unemployment associated with a small increase in the rate of inflation as inefficient, because the increase in employment results from workers being misled into accepting jobs that will turn out to pay workers a lower real wage than they had expected. But even if that is so, the increase in employment may still be welfare-increasing, because the employment of each worker improves the chances that another worker will become employed. The social benefit of employment may be greater than the private benefit. In that case, the apparent anomaly (from the standpoint of the natural-rate hypothesis) that measurements of social well-being seem to be greatest when employment is maximized actually make perfectly good sense.

In an upcoming post, I hope to explore some other possible explanations for low real interest rates.


About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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