The Mythology of the “Natural Interest Rate”

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Myth : A huge and growing global savings surplus during the first two decades of this century has pressed down the natural rate (some say neutral rate) of interest. Actual very-low and sometimes negative market rates of interest reflect this.

Reality : Estimates of the neutral rate according to central bank consensus definition have fallen, but these involve dubious “top-down” observations about economic aggregates and theoretical constructs based on an unsound money regime.

Central bankers and their governments are prone to embrace claims that low rates are now “natural.” If unnatural, they would be levying in full sunlight a giant monetary repression tax (at a rate equal to the spread of the natural rate over the market rate which the central bankers are manipulating and levied on government bond and money liabilities).

But the claims about an actual low natural rate are bogus.

First, take the “savings surplus” claim.

It is true there are huge savings surpluses in some parts of the world – especially North-West Europe (Germany, Netherlands, Switzerland) and East Asia (Japan, Taiwan, Singapore). But there are also large deficits to match – in the US, UK, Canada, Latin America.

In the two decades before World War One, France and Britain ran savings surpluses (current account surpluses in their balance of payments) of around 10 per cent of estimated economic size without anyone talking about global savings surplus pressing down global interest rates. In fact, money rates in London, as always under the gold standard, remained at or above 2 per cent except during short exceptional periods.

A spread of surpluses and deficits around the globe reflects divergencies in savings and investment opportunities alongside strong preferences of investors for certain currencies and political jurisdictions.

Yes, according to some measures, business spending on investment so far in the 21st century has been weaker than normal in advanced economies (especially in this second decade), which could go along with swollen savings surpluses. In this case, though, that connection is tenuous, given that low business spending may well not indicate a natural fading of investment opportunity. Rather, it may be the depressing effect of monetary manipulations.

Radical monetary policy makes many business decision-makers adverse to long-gestation investment out of fear that the chickens of asset inflation will eventually come home to roost. Moreover, the asset inflation has spurred the build-up of monopoly power, (think of the fantastic valuations of firms, for example, like Big Tech or Amazon which have this now or are apparently on the way to having it soon), itself inimical to wider entrepreneurship and investment.

Second , take a set of claims as to why the natural rate of interest is abnormally low stemming from flawed concepts applied by monetary policy makers.

To be fair, all the flaws did not originate with today’s central bankers.

Some go back to their economist “ancestors,” especially Knut Wicksell, who considered “stable prices” as a central condition of economic equilibrium, while arguing that the natural rate, though superficially hidden, did reveal itself through the course of time. This occurred through price pressures.

If market rates dropped on a sustained basis below the natural rate, pressures would develop from rising prices for market rates to rise and conversely. These pressures were in the context of automatic monetary rules (Wicksell’s writings were in a gold standard context).

Unsurprisingly, Wicksell’s theory found favour with John Maynard Keynes and Irving Fisher in the next generation, who in their different ways were writing prescriptions as to how the suddenly emerged monetary hegemon, the Federal Reserve, should set policy rates (a dilemma which did not exist under the pre-1914 gold standard). Both were partisans of stable prices and antagonistic to sustained falls in prices of goods and services (what today we would describe as deflation phobia).

Some sound money theorists (including Ludwig von Mises) by contrast, were unsympathetic to Wicksell’s natural rate, seeing stable prices as a very long run tendency only, not the benchmark for the medium-term. There could be extensive periods during which non-monetary forces were driving prices downwards – possibly extending well beyond one business cycle.

Accordingly, the natural rate should be founded on prices reverting to the mean (not an absolute constant) over the very long run but allowing for some rhythm of prices up and down during shorter periods. As no-one, however, can measure precisely this rhythm, let alone forecast it, the identification of a natural rate of interest is a complex, indeed some would say impossible task, not worth the candle. Better to allow market rates to be freely determined (no setting of policy rates by the central bank) under a sound money regime. Long-term rates would then have significant informational content drawn from a huge number of decentralized investment and savings decisions.

One should not be too much the purist here. Non-monetary real forces under a sound money regime could influence the supply of money and so induce some monetary inflation – but this would be modest in the greater picture (not remotely on the scale of modern central banks pursuing their two-percent inflation targets). For example, price and cost falls would lead eventually under a gold standard to an increase in gold production for some time. Indeed, that response of gold supplies is essential to the tendency of prices to revert in the very long run to the mean (under the gold standard).

Back to today’s Federal Reserve. According to its senior officials, they are gazing at “r star” (neutral rate), otherwise r*, attempting continuously to improve their estimates as to its size and position. Like Wicksell, they believe in revelation (of hidden neutral), but also think that powerful application of econometrics will help in that process. The aim is price stabilization over the short and medium and long run, where this means perpetual price rises at two percent per annum.

The US central bank has been applying this doctrine for two decades (and especially the last decade) where first globalization and then digitalization have been key sources of non-monetary downward pressure on prices. There has been no accompanying surge in measured productivity growth; even so the nature of the technological shifts has been to drive prices and costs lower. For example, these shifts have reduced the power of labour and fostered the growth of “star firms” which somehow prevent the source of their technological and organizational superiority from seeping out whilst creating harsh competition for outsiders.

The downward pressure on prices has provided scope for the Fed and foreign central banks to lower rates to abnormally low levels. The absence of any inflation acceleration “justifies” their claim that the neutral rate (r*) must have fallen. Asset inflation is a contrary indicator to this claim – but they never talk about this and pooh-pooh the talkers about it.

There is no reason to think that the true natural rate — which as discussed is too complexly hidden to ever estimate with any precision — has in fact come down at all. What we have discovered in this longest of ever US cyclical expansions is that the potential gap between the true natural rate and market rates could be larger and more persistent than any of us would have imagined. The long and relentless pressure of non-monetary forces downwards on prices and costs is responsible. No one should fool themselves that these forces endure.

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