The Fed and Bernanke Are Wrong About the Natural Interest Rate
A few days before the last FOMC meeting The Wall Street Journal reported on the Fed's hand wringing over its inability to identify the “natural rate of interest” and explain its recent movements. According to the report, the Fed uses the “mysterious natural rate” to guide its decisions in setting the target for the fed funds rate. Modern macroeconomics defines the natural rate of interest as the (real) rate of interest that maintains the economy in a Keynesian state of bliss, with stable prices (or moderate inflation) and actual real GDP equal to “potential” or full-employment GDP.
According to Fed economists, the natural rate is “unobserved” and therefore “has to be inferred from observable data” using econometric models or other statistical techniques. But different models yield different estimates of the natural rate. These estimates range from “persistently negative since 2008,” to a “reasonable range” between 1% and 2%. Nor are these estimates very precise. One model estimates a natural rate of 0.5% from 2010–2015 with a 90% confidence interval of 4 percentage points, meaning that there is a 90 percent probability that the natural interest rate lies somewhere between -1.5% and 2.5%. Another model yields an estimate of the natural rate for the year 2000 that includes both 0% and 6% within the 90% confidence interval! But the main problem befuddling monetary policymakers is that almost all estimates have indicated that the natural rate has fallen precipitously: from 2 to 2.5% leading up to the financial crisis, to near or even slightly below zero-- and has remained there since 2009. Furthermore, the rate shows no signs of recovering despite the fact that the real economy has considerably strengthened since 2009.
Fed policymakers and macroeconomists are struggling mightily to explain this phenomenon of a zero natural rate. Larry Summers has revived Alvin Hansen's silly and long discredited secular stagnation thesis of the 1930s to explain the super-low natural rate. According to Summers's version of this thesis, the slowdown in population growth, the transition from a manufacturing to a less capital-intensive service economy, and an inexplicable decline in the relative price of capital goods and consumer durables in the US economy has caused the demand for investment funds to decline, driving down the natural rate. Ben Bernanke has dusted off and presented anew his absurd savings glut hypothesis, arguing that the natural rate is languishing near zero because the world is awash in an excess of unneeded savings. Bernanke first advanced this claim ten years ago to deflect blame from Fed monetary policy for creating the housing bubble. And Janet Yellen offers the unhelpful view that the level of the natural interest rate “is something we are uncertain about and have to find out over time.”
Unfortunately, despite the confusion it has wrought, the putatively low natural rate serves as a ready-made excuse for the Fed to continually delay raising the fed funds target rate lest it push the interest rate above the natural rate, suppressing investment and consumption spending and plunging the economy into deflation and depression.
There are a number of problems with the conventional conception of the natural rate. It rests on abysmal ignorance of the history of economic thought. It also profoundly misconceives the relationship between the financial and real sectors of the economy. These misconceptions of the origin and essence of the natural rate lead to a monetary policy that renders wholly futile all attempts to empirically identify or “estimate” its level.
Let us start with the first point. The current definition of the natural rate is commonly attributed to Knut Wicksell, the brilliant Swedish economist who originated the concept in a book in 1898. For example, without explicitly mentioning Wicksell, Krugman defines the natural rate as “a standard economic concept dating back a century; it’s the rate of interest at which the economy is neither depressed and deflating nor overheated and inflating.” Bernanke refers to the “equilibrium real interest rate,” which he says is “sometimes called the Wicksellian interest rate.” Bernanke defines it as “the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment.” Richmond Federal Reserve Bank economists Lubik and Matthes also invoke Wicksell as the originator of the concept:
Its modern usage dates back to the Swedish economist Knut Wicksell, who in 1898 defined it as the interest rate that is compatible with a stable price level. ... In Wicksell’s view, equality of a market interest rate with its natural counterpart therefore guarantees price and economic stability.
These contemporary statements of the natural rate generally cite only a very small fragment of Wicksell’s discussion of the concept in which he refers to the natural rate as “a certain rate of interest on loans which is neutral in respect to commodity prices, and tends neither to raise nor to lower them.” (See, for example, here and here). But if we look closely at the definition of the natural rate by Bernanke, Krugman et al., we find that it is really drawn from Keynes’s work and not from Wicksell’s. For it is simply the interest rate that is consistent with full employment of resources at a zero, or non-accelerating, inflation rate. Indeed in The General Theory of Employment, Interest, and Money (pp. 242–43), Keynes explicitly rejected the Wicksellian natural rate as not being analytically “very useful or significant.” He went on to suggest that the natural rate be replaced by the concept of what he called the “neutral” or “optimum” rate of interest, which is the interest rate “which prevails in equilibrium where output and employment are such that the elasticity of employment as a whole is zero” — which is a clumsy and pretentious way of describing the state of full employment or what is in today’s jargon called “potential GDP.” So for Keynes and his contemporary disciples the natural or neutral rate of interest is determined wholly in financial markets and is one of the main determinants of the level of investment spending and the real rate of return on investment.
This conception is the polar opposite of the natural rate of interest as conceived by Wicksell. According to Wicksell (p. 205) who was a follower of Böhm-Bawerk and an Austrian capital theorist through and through, “the natural rate of interest [is] the real yield of capital in production.” The natural rate is thus an “intertemporal” price, or the ratio of prices between present consumption and future consumption (as embodied in capital goods), and it is wholly and directly determined by capital investment in the real sector of the economy. The loan rate of interest is therefore a mere shadow of the natural rate. As Wicksell (p. 192) put it: “That loan rate that is a direct expression of the real rate, we call the normal rate.” This “normal” or “natural” loan rate derives from the natural rate of return on investment throughout the economy’s capital structure and moves in near lock-step with it: “The rate of interest at which the demand for loan capital and the supply of savings exactly agree ... more or less corresponds to the expected yield on the newly created capital.”
For Wicksell, then, in sharp contrast to Keynes, the natural rate is a real price spontaneously determined by market forces, to which the loan rate normally and automatically tends to adjust. In his view, one of the main reasons why the two rates might substantially diverge from one another is because fractional-reserve banks have the power to expand credit by lending deposited gold or, more likely, creating and lending out bank notes and what he called “fictitious deposits.” The expansion of credit by the banks drives down the loan rate below its “normal” equivalence to the natural rate. The divergence between the two rates induces entrepreneurs to eagerly borrow the additional funds at the loan rate and invest them in production processes yielding the higher natural rate of return. The result is an increase in the demand for labor, raw materials, commodities and machinery and a bidding up of wages rates and other factor prices and rents. The additional money payments to laborers and other resource owners eventually cause a rise in the demand and prices of consumer goods. The result is what Wicksell called a “cumulative process” of general price increases that lasts as long as banks suppress the loan rate below the natural rate. The inflationary cumulative process comes to an end only if and when credit expansion ceases and market forces are permitted to establish equality between the loan and natural rates. Theoretically, the gap between the two rates could cause an “unlimited” rise in prices. Wicksell also maintained that a cumulative process of inflation or deflation could be precipitated by a failure of fractional-reserve banks to adapt the loan rate quickly enough to an initial rise or fall in the natural rate of interest by contracting or expanding credit.
It is worth noting that Ludwig von Mises, in The Theory of Money and Credit (pp. 349–66) originally published in German in 1912, developed the Austrian theory of the business cycle on the foundation of Wicksell’s crucial analysis of the distinction between the loan rate and the natural of interest. Unwilling or unable to comprehend this distinction, Keynes in the General Theory (pp. 192–93) charged Mises along with Friedrich Hayek and Lionel Robbins with “confusing the marginal efficiency of capital with the rate of interest.” Keynes’s “marginal efficiency of capital” was his peculiar term for the expected rate of return on investment — which is nothing other than Wicksell’s natural rate.
In the current era, serious engagement with the history of economic thought is actively discouraged in PhD programs in economics. Contemporary macroeconomists therefore fail to grasp the difference between Wicksell’s and Keynes’s definitions of the equilibrium interest rate and confuse the provenance and meaning of what they call “the natural rate.” Their view is that the natural rate is an elusive, non-market “policy goal” subject to sudden and inexplicable fluctuations, which must be laboriously extracted from the data using statistical methods. In order to maintain economic stability, the Fed must continually manipulate the fed funds target rate to roughly approximate the natural rate. But, as we have seen, because Fed policymakers deny that the true natural rate can ever be known with certainty, they argue that the Fed must use its own judgment and discretion in conducting monetary policy.
Wicksell and modern Austrian economists — who are Wicksell’s true heirs — hold a conflicting view of the natural rate. They argue that the natural rate is a real and observable market phenomenon that is ultimately determined by the consumption/saving preferences of households and effected by entrepreneurial decisions about the allocation of resources among consumer goods’ and capital goods’ industries based on anticipations of these preferences. The decisions of entrepreneurs tend to bring the rate of return on capital investment into equilibrium across all production processes and business firms in the economy. This rate is reflected in the interest rate on the loanable funds market, which is merely a component of the overall capital or intertemporal market. The latter market includes all funds used to purchase factors of production whether the funds are borrowed or directly invested by shareholders, partners, and proprietors into their own corporations and privately-held firms.
It is thus continual creation of bank reserves out of thin air via Fed open market operations that facilitates the continual expansion of bank credit and drives the loan rate below the natural rate determined in the free and unfettered intertemporal market. For Austro-Wicksellians, then, if the goal of monetary policy is really to adapt the rate in financial markets to the natural rate of interest, then all the Fed needs to do is to cease all open market operations, slam the discount window shut, and freeze reserve requirements at current levels. This undoubtedly will involve a short and sharp bout of recession and liquidation of unsound firms and investments. But if the Fed refrains from interfering — as was the case, for example, in the 1920–21 depression — the process of recession-adjustment will swiftly return the economy to a sound footing and the Wicksellian natural rate will at long last manifest itself for all to observe in the interest rates and yields across financial submarkets. (See Jim Grant, The Forgotten Depression, 1921: The Crash that Cured Itself.)
Ironically. the Fed’s ongoing manipulation of interest rates in relentless pursuit of the illusive and misconceived Keynesian natural rate causes the true Wicksellian natural rate to remain “unobservable” — and distorts financial markets and produces economic instability in the bargain. Bernanke unwittingly made this very point, when he wrote:
A similarly confused criticism often heard is that the Fed is somehow distorting financial markets and investment decisions by keeping interest rates “artificially low.” Contrary to what sometimes seems to be alleged, the Fed cannot somehow withdraw and leave interest rates to be determined by “the markets.” The Fed’s actions determine the money supply and thus short-term interest rates; it has no choice but to set the short-term interest rate somewhere. So where should that be?
Actually, it is Bernanke who is badly confused and has completely misunderstood Wicksell’s analysis of the natural rate. Certainly, the Fed affects interest rates when it determines the money supply. But this begs the question. If the Fed were to completely halt its manipulation of the money supply, the loanable funds market would not disappear nor would interest rates become indeterminate. The supply of loanable funds would simply shift to the left and the interest rate would rise to a new equilibrium that aligns the loan rate with the long-run rate of return on investment in the real production structure. Wicksell’s natural rate would finally emerge for all to see. It is precisely the Fed’s attempt “to set the short-term interest rate somewhere” that causes it to be unobservable anywhere.