by Enrico Colombatto In the summer of 2016, commentators began […]
by Enrico Colombatto
In the summer of 2016, commentators began predicting that monetary policy in the United States would no longer aim to avoid deflation and boost growth, but instead would try to keep market interest rates close to what economists call the “natural rate of interest.” This objective was widely reported in the media and never denied by the U.S. Federal Reserve. Indeed, senior officials such as Vice Chairman Stanley Fischer have publicly expressed concern that structural changes in the economy may have caused a sustained reduction in the natural interest rate.
pon closer examination, the reasoning behind this argument is perplexing. The market rate of interest is what we observe every day. It is generated by the interaction between the supply and demand of financial resources, wherever they come from. Supply includes household savings and new money created by the central authorities. Of course, the more money rolls off the central bank’s printing presses, the more funds are available on the markets, and the lower the market rate of interest.
By contrast, the natural rate of interest is the rate one would observe if the supply of funds were not altered by money printing. It is the rate that would be generated by the interaction between borrowers (consumers and investors) and lenders (savers) with no governmental intervention. Of course, when money printing is substantial, the market rate of interest drops well below the natural rate.
If the Fed really wanted to ensure that the market and the natural rates of interest were the same, the obvious course of action would be to do absolutely nothing and give up monetary policy altogether. However, since self-dissolution is probably not what Fed Chair Janet Yellen and the U.S. political establishment have in mind, references to this unusual notion – the natural rate of interest – might signal a change in the Fed’s monetary views and possibly new scenarios.
The starting point is clear. The American economy is in rather good shape. The current rate of economic growth may not be stellar (still below 2 percent on an annual basis), but it is accelerating, while the unemployment rate remains low (4.7 percent). Consumer confidence is high and manufacturing also seems healthy. Moreover, annual inflation is at 2.1 percent – exactly what policymakers want to see.
In short, the Fed is facing an environment in which even the staunchest advocate of active monetary policy would argue in favor of a neutral stance. In this context, the reference to the natural rate of interest seems justified. However, while the economic logic of the natural interest rate theory suggests that monetary policy should simply be banned, the Fed’s view is probably different. Our suggestion is that it could mean two things, depending on the circumstances.
Firstly, the Fed may believe that while the market rate of interest should indeed be equal to the natural rate of interest when everything runs smoothly, the natural rate might no longer be appropriate when the economy is in trouble. Such conditions would justify intervention and the very existence of central banking. Secondly, referring to the natural rate of interest could be a message to the other branches of government, a way of letting people know that a new target is being adopted and that this new target is less open to public discussion.
As mentioned earlier, the only way to pinpoint the natural rate of interest is to let the market find its level through repeated interactions. This level would fluctuate continuously, since the supply and demand of funds are subject to constant change. It is therefore impossible to reliably forecast the future natural rate of interest.
However, the Fed might believe that by guessing about where that level is heading, and by evaluating whether it is appropriate, its monetary interventions can be made more timely and effective. For example, the Fed might believe that the natural rate of interest is now higher than the market rate – say, because of excessive credit created by the monetary policy of recent years – and that the economy is healthy enough to operate at the natural rate of interest.
This boils down to saying that the Fed is about to drain away liquidity and allow market interest rates to rise. Not surprisingly, this is consistent with the Fed’s recent announcements about a more restrictive policy approach throughout 2017.
Yet why should the Fed resort to the natural interest rate – and justify its actions by referring to the alleged gap between the natural and the market rate – when everybody is already expecting monetary tightening in 2017? One possible answer is that the policymakers believe they are under attack, and want to make their future moves less predictable, less transparent and less easily influenced by the new president and Congress.
If the central bank’s objective is expressed in terms of inflation or growth, monetary policy becomes almost automatic. The job of the Board of Governors boils down to reviewing the numbers and acting accordingly. At the same time, policymakers are constantly exposed to second-guessing by the market and by politicians – including possibly the president himself – for being too fast or slow, too bold or timid.
By contrast, the monetary data are more difficult to read, and analyzing the supply and demand of credit will always be beyond the grasp of the average politician, let alone ordinary citizens. Fed economists are unlikely to find many willing partners for a technical discussion about the natural rate of interest.
There is another reason why policymakers might want a convenient pretext to avoid public scrutiny over the next few months. The Fed is about to embark on a very ticklish operation: executing an economic soft landing after years of extremely relaxed monetary conditions. There are at least four major sources of uncertainty – all in some way linked with the dollar exchange rate – that the Fed would clearly like to tackle without too much outside interference.
First, if President Donald Trump follows through with his promises to introduce protectionist trade practices, net capital flows into the U.S. will follow, and these might lead to a significant appreciation in the dollar. Second, the currency will be further strengthened if the new administration runs larger budget deficits (for example, to fund more military and infrastructure spending) that will be covered by selling more debt to foreign investors. Most probably, this phenomenon will also push up interest rates, since higher levels of indebtedness will require additional incentives (higher returns) for prospective buyers.
Third, the European Union remains vulnerable to a banking and fiscal crisis, which would trigger an outflow of funds from the euro area. Once again, a flight to safety would boost the price of U.S. securities – both stocks and bonds – along with the exchange rate of the dollar. Lastly, one must consider the possibility of a domestic political crisis if the Trump administration fails to win at least minimal acceptance for its policies from Congress and the public. Should a sense of uncertainty prevail, market interest rates would rise and the dollar would weaken.
These eventualities suggest why the Fed may be anxious to keep ample discretionary power and resist pressure from outside. For example, one might predict that the Trump administration would resent an overly strong dollar, which would hurt U.S. exports and make life difficult for domestic producers trying to fend off foreign competition. From Donald Trump’s perspective, a strong dollar would transform his America-first trade policy into a botched experiment and a disappointment to his core constituency.
Historically, the U.S. Federal Reserve has never cared much about the dollar exchange rate. We see little reason for this to change in the future. Yet policymakers do seem determined to bring easy money to an end, before it fuels excessive inflation. In this light, the Fed’s recent references to the natural rate of interest might be a veiled message to the new president: it is high time we stopped deviating from the fundamentals, whatever happens to the dollar and the budget deficit.
If this hypothesis is correct, the U.S. monetary authorities will not support a new wave of Keynesian policies. That suggests we should be bracing for higher interest rates and possibly a stronger dollar, much to the dismay of President Trump.
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