Federal Reserve research supports the view that the natural rate of interest in the U.S. has not recovered from its plunge to an unprecedented historical low of close to zero after the great recession. This bodes for protracted problems with the zero lower bound emphasizing the ongoing importance of asset purchases and other non-conventional policy options for central bank credibility.

Laubach, Thomas, and John C. Williams (2016). “Measuring the Natural Rate of Interest Redux,” Finance and Economics Discussion Series 2016-011. Washington: Board of Governors of the Federal Reserve System,
http://dx.doi.org/10.17016/FEDS.2016.011.

This paper contributes to the basic understanding of the forces that perpetuate non-conventional monetary policy, as outlined in the related summary page.
Previous posts on the subject dealt with the deflationary bias at the zero lower bound (view post here)  and the need for particularly easy monetary policy as a form of central bank risk management (view post here).

The below are excerpts from the paper. Headings, links and cursive text have been added. Some acronyms and technical terms have been replaced by simplified language.

What is the natural rate of interest?

“We [define]…the natural rate as the real short-term interest rate consistent with the economy operating at its full potential once transitory shocks to aggregate supply or demand have abated. Implicit in this definition is the absence of upward or downward pressures on the rate of price inflation relative to its trend. Our definition takes a ‘longer-run’ perspective, in that it refers to the level of real interest rates expected to prevail, say, five to 10 years in the future, after the economy has emerged from any cyclical fluctuations and is expanding at its trend rate.”

“[The figure below] portrays a highly stylized model of the determination of the natural rate. The downward-sloping line, labelled the IS [investment-saving] curve, shows the negative relationship between aggregate spending and the real interest rate. The vertical line indicates the level of potential GDP. At the intersection of the IS curve and the potential GDP line, real GDP equals potential, and the real interest rate equals the natural rate of interest.”

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How to estimate the natural rate of interest?

“The natural rate of interest may change over time owing to highly persistent structural shifts in aggregate supply and demand… there are myriad influences on the natural rate, including, but not limited to, productivity growth, demographics, and the evolution of the global economy…One observation stands out from…[time series charts]: there are sizable swings in average real interest rates that persist for decades.”

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“Although [line charts with moving averages and filters] could…work well at estimating the natural rate of interest when inflation and economic activity are relatively stable, they are likely to be unreliable during periods when this is not the case, For example, during the late 1960s and much of the 1970s, inflation trended steeply upward in the United States, which suggests that the real funds rate was below the natural rate on average. Similarly, real interest rates were very high during the period of the Volcker disinflation of the early 1980s, when inflation fell sharply.”

“In light of these problems…we instead use a multivariate model that explicitly takes into account movements in inflation, output, and interest rates. In the Laubach-Williams (2003) model, the natural rate of interest is implicitly defined by the absence of inflationary or deflationary pressures…Specifically, the natural rate is assumed to depend on the estimated contemporaneous trend growth rate of potential output and a time-varying unobserved component that captures the effects of other unspecified influences on the natural rate.”

“Roughly speaking, the model…[relates the output gap  to] its own lags and…the difference between the actual real interest rate and the natural rate…If the output gap turns out to be lower than expected, the model responds by reducing the estimate of the natural rate…The output gap estimate in turn is informed by an estimated Phillips curve…In particular, if inflation turns out lower than predicted…the level of potential output is being revised up (that is, for a given level of real GDP, the output gap is revised down).”

What happened after the great recession 2008/2009?

“The ex post real fed funds rate–defined as the nominal effective federal funds rate less the percent change in the personal consumption expenditures price index over the prior year– has averaged about 2% over the past 50 years.”

“Since then start of the Great Recession the natural rate of interest has fallen to, and remained at, historically very low levels near zero. This is in part explained by a significant decline in the trend growth rate of the economy…We find no evidence that the natural rate has moved back up even with the economy close to fully recovered from the Great Recession. These results are robust to alternative approaches to estimating the natural rate of interest and the output gap.”

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“With core inflation remaining surprisingly stable in the face of sharp declines of real GDP below the trend implied by the pre-crisis trend growth rate of around 3 percent, the model assigned…a large share to declines in potential output and its trend growth rate. In fact, from mid-2008 to mid-2009, the model saw the level of potential output contracting by 2¼ percent, and the estimate of the trend growth rate declined by nearly ½ percentage point. The slow pace of GDP growth over the subsequent three years, combined with stable inflation, reduced the trend growth estimate further, to roughly 2¼ percent.”

“With the federal funds rate close to zero from early 2009 on, and core inflation averaging around 1-1/2 percent, the implied real rate gap would have been -3-1/2 percent. Such a large negative real rate gap would have predicted a much sharper rebound in the output gap than actually occurred. The  estimate of the natural rate of interest therefore fell rapidly to ½ percent in mid-2009, and then continued to decline to around zero by the end of 2010, cutting the implied real rate gap to about -1-1/2 percent. This represents an unprecedented decline and an historical low level of the natural rate over the past half century for which we have estimates.”

What are the consequences for monetary policy?

“If the natural rate were to remain as low as it has been since 2008, episodes in which short-term interest rates would be constrained from below would become more frequent and long-lasting, and unconventional policy tools may continue to play an important role in the future.”

“While the use of large-scale asset purchases appears to have been a powerful policy tool when short-term rates were constrained by the zero lower bound following the financial crisis, it is unclear whether a permanent expansion of the central bank’s balance sheet would permanently reduce longer-term interest rates and thereby increase the natural rate of interest.”

“Central banks could aim to reduce nominal interest rates below zero, as has been done to a limited extent in several European jurisdictions. Even though a number of institutional hurdles may make it difficult to reduce nominal interest rates to levels that might be called for in response to a major recession, negative short-term interest rates in combination with forward guidance and asset purchases would provide central banks with a potent set of tools to respond to undesirably low inflation and economic weakness.”

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Ralph Sueppel is founder and director of SRSV, a project dedicated to socially responsible macro trading strategies. He has worked in economics and finance for over 25 years for investment banks, the European Central Bank and leading hedge funds. At present, he is head of research and quantitative strategies at Macrosynergy Partners.