Something Wicksell this way comes
Are real rates too high or too low?
Yet out there, somewhere, is a “correct” interest rate, sometimes called the natural interest rate, or Wicksellian rate. This week’s Free Exchange column explains:
Over a century ago Knut Wicksell, a Swedish economist, drew the distinction between the financial rate of interest that borrowers actually pay and the natural rate of interest that was determined by the return on capital. If the financial rate is below the natural rate, businesses can reap unlimited profits by borrowing as much as they can and ploughing it into high-returning projects. Eventually, though, all that additional spending pushes up prices, money and credit, and eventually, financial interest rates.
The natural interest rate is often assumed to be constant. … But, according to Wicksell, the natural rate is “never high or low in itself, but only in relation to the profit which people can make with the money in their hands, and this, of course, varies. In good times, when trade is brisk, the rate of profit is high, and, what is of great consequence, is generally expected to remain high; in periods of depression it is low, and expected to remain low.”
Central banks pay implicit homage to Wicksell. Their models, for instance in this paper by Thomas Laubach and John Williams, assume the existence of an equilibrium real rate of interest that keeps the economy operating at potential. Keep the actual rate below the equilibrium rate, and the economy speeds up, eventually generating inflation. Keep it above, and it slows down, eventually tipping into recession. But unlike Wicksell, the Fed does not invoke the difference between the financial rate and the return on capital to explain how monetary policy works. Indeed, the empirical link between capital spending and interest rates is not very strong. Rather, the primary channels by which monetary policy works are household durable consumption, housing, and financial variables such as the exchange rate and the stock market.
At root, though, Wicksell’s original formulation is still relevant. Households may not think of themselves as having some target return on capital, but they still have preferences for consuming now versus consuming in the future. Atering interest rates, by bending those preferences, can stimulate or dampen aggregate demand today. Make the real interest rate negative enough, and the increased pleasure that comes from consuming today vs saving and consuming tomorrow becomes overwhelming. This, ultimately, is why the IS curve in the IS-LM model slopes down.
As Greg Mankiw and John Campbell noted back in 1989, it’s hard to find a strong, empirical connection between movements in real interest rates and movements in consumption. After crunching the numbers, they found that consumption responded far more to expected income. This doesn’t mean there’s no role for the interest rate; it could be that, to influence consumption, the interest rate must offset opposite pressure from changes in expected income. In other words, when consumers expect to be much wealthier in the future, they are more willing to borrow against that wealth. To prevent an inflationary surge in consumption, the central bank tightens. When households expect to be less wealthy, they don’t want to borrow until the central bank lowers interest rates enough.
That seems to be what ails America now. The University of Michigan each month asks households how much they expect their income to grow in the coming year, and as the nearby chart shows, those expectations have collapsed. Since the start of 2009, the median household has expected its income to grow just 0.4% in the next 12 months, i.e. decline in real terms.
If we want to think of households in Wicksellian terms, we might say that households’ internal rate of return has plunged; the pleasure taken from consuming a borrowed dollar today is simply not worth the pleasure forsaken when that dollar must be repaid tomorrow. In effect, households’ own natural interest rate is depressed. So depressed that even zero nominal rates have not boosted consumption that much.
Since the interest rate in the short run, and these days (thanks to quantitative easing and forward guidance) in the medium run, is so heavily influenced by the Fed, we cannot definitively say whether the natural rate is high or low, and thus whether the Fed is being too loose or too tight. Bill White, formerly of the Bank for International Settlements, has arguedthe Wicksellian natural rate must be high and monetary policy too loose because low rates have encouraged all sorts of yield-chasing behavior. But Brad DeLong responded:
[W]e don’t see businesses dipping into their cash reserves to fund investment; a monetary hot potato; unexpected and rising inflation; and full or over-full employment.
Instead, we see elevated unemployment and firms and households adding to their cash reserves. This is what Wicksell expected to see when the natural rate of interest was below the market rate: planned investment would then be lower than desired savings, households and businesses seeking to save would be unable to find enough bonds to balance their portfolios, they would then transfer some of their cash out of transactions balances and treat them as unspendable savings (the “precautionary” or “speculative” demand for money), we would see too little money to buy all the goods and services that would be put on sale at full employment, and we would see no signs of inflation but a depressed economy.
That is the root of our problem: the natural nominal rate of interest … today is less than zero, and so the Federal Reserve cannot push the market nominal rate of interest down low enough.
This story is not inconsistent with the behavior that alarms Mr White and other critics of the Fed. Businesses and households’ internal rates of return on investment and consumption could be extremely depressed, while financial rates of return on leveraged investments could be high, at least in the fevered, speculative minds of the people making them.
It’s easier to make a judgment on whether the Fed has it right by looking to the future when the Fed has finally started tightening and the zero lower bound no longer binds. The Fed has already said it expects real rates to be zero in 2016, when unemployment is virtually back to its natural level of around 5.5%. Moreover, as the article shows, the same phenomenon prevails to varying degrees in most developed markets.
This of course may simply mean that all those central banks are either running variants of the Fed’s policies, which will keep rates low for a long time, or are heavily influenced by the Fed. But the fact that demand is not exactly booming in any of these markets seems more consistent with the natural rate being depressed. If central banks were to raise the actual interest rate today, it could be the equivalent of ordering service stations to raise the price of petrol, causing demand to collapse. Ultimately, the higher price would not hold. And there would be a lot of glum drivers.