Natural interest rate

Negative Nominal Interest Rates (again)

There is an obsession with negative nominal interest rates. People seem to think that they make no sense. And, there is a fixation with keeping track of the fraction of sovereign debt that is trading at negative nominal rates. (At this writing, the number is approaching one-third of the total outstanding.) Clearly many central bankers believe that setting the policy rate below zero is a legitimate use of this conventional instrument, a point that we have supported in the past. But the fact that people are so disturbed prompts us to ask why. In this post, we first discuss why we are confused by this reaction, and then try to identify what might account for it....

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The FOMC's Prudent Caution

Imagine Fed Governor Rip van Winkle waking from a 10-year nap to find that trend inflation is only a bit shy of the 2% target, the unemployment rate is close to its long-run steady state, and the Fed’s balance sheet is five times larger than when he fell asleep. As we wrote two years ago, you could forgive him for expecting the federal funds rate to be closer to 4% than ½%. And, you would understand his astonishment when he learns that financial market expectations of policy tightening have collapsed amid continued economic expansion.

So, why are both the current policy rate and expectations of the future rate so low? There are four powerful reasons. First, both investors and policymakers have lowered their estimates of the steady-state (or “natural”) real interest rate. That means that Fed policy today is less accommodative than Governor Rip’s 10-year-old perspective leads him to think. Second, Rip is surely startled to learn that, even with a tightening labor market and policy rates close to zero, market-based long-run inflation expectations have declined. Third, it seems unlikely that Rip would be thinking much about the policy asymmetry that occurs when the nominal interest rate is near the effective lower bound. That is, as post-crisis experience suggests, with policy rates near (or even below) zero, it is much easier for central banks to tighten when prices rise too quickly than it is to ease should prices start to fall. Fourth, the economy’s productive capacity may be endogenous: that is, it may be possible for trend growth to be higher than recent experience suggests...

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Living with uncertainty: What central banks do when they don't know the natural rate

“Unfortunately, we have as yet devised no method to estimate accurately and readily the natural rate of either interest or unemployment. And the ‘natural’ rate itself will change from time to time.” Milton Friedman, American Economic Association Presidential Address, 1968.

What do you do if, on a dark and foggy night, you are forced to drive on a road with a sheer cliff on one side? Unless you know precisely where the road ends and the cliff begins, you will likely go slowly and keep your foot near the brakes. Driving like a tortoise is not the “first best” solution  – fog lights that distinguish the road from the cliff would be better. But, absent proper illumination, going slowly is a safe response to perilous driving conditions. It helps prevent catastrophic, irreversible errors.

Such robust strategies are key to central bankers' success as well...

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