A natural long-term rate

Central banks ignore this century-old observation at their peril

Oct 26th 2013 | From the print edition

[Greg Ip] WHEN Federal Reserve officials released their latest round of economic projections last month, they included a striking revelation. Three years from now, the Fed reckons, America will be back at full employment with a jobless rate very close to its long-term level of about 5.5%. Yet monetary policy will still be exceptionally easy, by historical standards. Fed officials reckon the federal-funds rate will be just 2% by the end of 2016, zero in real terms. In previous decades, real rates ranged from 1% to 5% when unemployment was that low.

Depending on whom you ask, such a prolonged period of negative or zero real rates is proof that the Fed is either dangerously irresponsible or admirably resolute. Both interpretations imply that the Fed is in control. But the truth is more subtle. The central bank may tweak rates from month to month but, in the long run, deeper factors determine the “natural” rate of interest, and the central bank defies them at its peril.

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.

Wicksell saw financial rates as those set by banks competing to make loans. That job is now performed by central banks. They still think in Wicksellian terms: the natural rate prevails when the economy is at full employment. Set the policy rate above the natural rate and the economy tips into depression. Set it below, and inflation results—or, some worry, speculative credit booms.

The natural interest rate is often assumed to be constant. The Taylor rule, a popular monetary-policy formula, tends to incorporates a real rate of 2%. 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.”

Although the Fed’s critics think it is holding financial rates well below the natural rate, this is at odds with plenty of other evidence. If investors thought today’s low rates were unsustainable, bond yields would be much higher, to reflect the likelihood of higher short-term rates in a few years’ time. To be sure, bond yields have been held down both by the Fed’s promise to keep rates low near zero, and its purchases of long-term bonds. Yet bond yields are just as low, if not lower, in countries with less explicit commitments. Economists at Goldman Sachs have plotted market expectations of short-term interest rates against consensus inflation forecasts to derive expected real policy rates for several major markets. The results show that real policy rates are projected to be even more negative in Japan and Britain in three years’ time than in America, and just as negative in the euro zone. Even in Australia and Canada, whose central banks avoided large-scale bond buying, real rates will still be unusually low.

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The new head of the Federal Reserve: Dove ascendant

Janet Yellen will stick to her predecessor’s expansionary policies

Oct 12th 2013 | WASHINGTON, DC | From the print edition

[Greg Ip] FOR most of the past few years, monetary policy has urged the economy on while dysfunctional fiscal policy has held it back. Barack Obama’s decision to nominate Janet Yellen to succeed Ben Bernanke as the Fed’s chairman in February raises the odds that stimulative monetary policy will continue. But disquiet about that stance is growing.

In addition to being the first woman to run the Fed, Ms Yellen is also the first acknowledged dove. Presidents once felt compelled to appoint monetary-policy hawks such as Paul Volcker and Alan Greenspan to reassure markets that the Fed would not succumb to the political system’s inflationary bias. In appointing Ms Yellen Mr Obama has implicitly acknowledged how much the world, and the Fed’s priorities, have changed. Since 2008 America, like many other countries, has struggled with slack demand and high unemployment. Meanwhile, energy prices excluded, inflation has persistently fallen short of the Fed’s 2% target.

The week in American monetary policy: Parsing the Federal Reserve

May 24th 2013, 18:39 by G.I. | WASHINGTON, D.C.

The Federal Reserve left a lot of people scratching their heads this week. Between Chairman Ben Bernanke’s testimony, and the release of the minutes to the May 1^st Federal Open Market Committee, investors were struggling to figure whether an end to easy monetary policy was nigh. A headline in today’s The Wall Street Journal declares: “In Bid for Clarity, Fed Delivers Opacity.” Here is what I think is essential to understand about what the Fed is doing, what we learned this week, and why more crossed signals are likely ahead.

1. The Fed has two exits to manage, not one.

The Federal Reserve speaks: Fearful symmetry

May 1st 2013, 21:45 by G.I. | WASHINGTON, D.C.

THE Federal Reserve, as widely expected, stood pat today, reaffirming its commitment to near zero interest rates until unemployment fell to 6.5% or lower, and continuing to buy $85 billion of Treasury and mortgage-backed bonds until the jobs market improved substantially.

But its otherwise ho-hum statement jolted markets with this new line: “The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.”

How Mrs Thatcher smashed the Keynesian consensus

Apr 9th 2013, 14:13 by G.I. | WASHINGTON, D.C.

[Greg Ip] In March 1981, 364 eminent British economists published a letter to Margaret Thatcher in The Times condemning her plans to hike taxes even as her monetarist attack on inflation plunged the economy ever deeper into recession. The signatories wrote:

There is no basis in economic theory or supporting evidence for the Government’s belief that by deflating demand they will bring inflation permanently under control and thereby induce an automatic recovery in output and employment … [P]resent politics will deepen the depression, erode the industrial base of our economy and threaten its social and political stability.

Kill bill

Will the deficit finally spur America to replace dollar bills with coins?

Mar 16th 2013 | Washington, DC |From the print edition
[Greg Ip] EARLIER this year the blogosphere was full of calls for America to pay its bills by minting a $1 trillion platinum coin. That idea has mercifully died, but the fiscal pressures that gave birth to it have provided the impetus for a less nutty variant: phasing out the dollar bill in favour of a dollar coin.

What QE means for the world: Positive-sum currency wars

Feb 14th 2013, 23:24 by G.I. | WASHINGTON, D.C.

Brazil’s finance minister coined the term “currency wars” in 2010 to describe how the Federal Reserve’s quantitative easing was pushing up other countries’ currencies. Headline writers and policy makers have resurrected the phrase to describe the Japanese government and central bank’s pursuit of a much more aggressive monetary policy, motivated in part by the strength of the yen.

The clear implication of the term “war” is that these policies are zero-sum games: America and Japan are trying to push down their currencies to boost exports and limit imports, and thereby divert demand from their trading partners to themselves. Currency warriors regularly invoke the 1930s as a cautionary tale. In their retelling, countries that abandoned the gold standard enjoyed a de facto devaluation, luring others into beggar-thy-neighbor devaluations that sucked the world into vortex of protectionism and economic self-destruction.

But as our leader this week argues, this story fundamentally misrepresents what is going on now, and as I will argue below, what went on in the 1930s. To understand why, consider how monetary policy influences the trade balance and the exchange rate.

The global economy: Phoney currency wars

The world should welcome the monetary assertiveness of Japan and America

Feb 16th 2013 |From the print edition
OFFICIALS from the world’s biggest economies meet on February 15th-16th in Moscow on a mission to avert war. Not one with bombs and bullets, but a “currency war”. Finance ministers and central bankers worry that their peers in the G20 will devalue their currencies to boost exports and grow their economies at their neighbours’ expense.

Emerging economies, led by Brazil, first accused America of instigating a currency war in 2010 when the Federal Reserve bought heaps of bonds with newly created money. That “quantitative easing” (QE) made investors flood into emerging markets in search of better returns, lifting their exchange rates. Now those charges are being levelled at Japan. Shinzo Abe, the new prime minister, has promised bold stimulus to restart growth and vanquish deflation. He has also called for a weaker yen to bolster exports; it has duly fallen by 16% against the dollar and 19% against the euro since the end of September (when it was clear that Mr Abe was heading for power).

The economics of the platinum coin option: Platinomics

Jan 9th 2013, 4:04 by G.I. | WASHINGTON, D.C.

In the many years I’ve spent scrutinizing monetary policy, I had never devoted more than a thought to coins. In the scheme of all things monetary, they seemed, well, pocket change.

Needless to say, the prospect of the Treasury issuing a $1 trillion platinum coin to circumvent the debt ceiling changes that. I won’t repeat the details; you can get up to speed by reading Matthew O’Brien of The Atlantic here and my colleague here. If nothing else, unpicking the consequences is a fun exercise. I’ve concluded the economics are more complicated and more benign than appreciated, but the political consequences are graver.

The Fed’s new thresholds: The mandate is willing but the tools are weak

Dec 13th 2012, 2:00 by G.I. | WASHINGTON, D.C.

[Greg Ip] Low inflation and full employment have been statutory goals of the Federal Reserve since 1977, but its officials always felt more comfortable with the first than the second. After all, in theory monetary policy can’t alter unemployment in the long run.

But the stubbornly weak economy of recent years prompted some at the Fed to question their historical neglect of the second half of their mandate. “The Fed’s dual mandate … has the force of law behind it,” Charlie Evans, president of the Federal Reserve Bank of Chicago, said in September, 2011.  “So, if 5% inflation would have our hair on fire, so should 9% unemployment.”