Has The Natural Interest Rate Been Negative for the Past Five Years?

In my last post I raised the question of whether the nominal natural interest rate has been negative since the crisis started. Many observers say yes and point to it as the reason why the economic slump has persisted for so long. For if this output market-clearing level of the interest rate has been negative while actual interest rates have been stuck near zero, then a general glut is the inevitable consequence. Others find this hard to believe. Even if the natural interest rate turned negative in 2008-2009, they question how it could remain negative for five years.

So is the nominal natural interest rate really negative five years after the crisis started? To answer this question we need to first recognize there is an entire term structure of natural interest rates. This means there is both a long-term and short-term nominal natural interest rate. The former is the determined by structural trends in the economy while the latter is driven by the business cycle.

More specifically, the long-term nominal natural interest rate is determined by trend changes in the expected productivity growth rate, the population growth rate, and household time preferences given well-anchored inflation expectations. Productivity matters because it affects the expected return to capital and expected household income. Faster productivity growth, for example, translates into a higher expected return on capital and higher expected household incomes. In turn, these developments should lead to less saving/more borrowing by firms and households and put upward pressure on the natural interest rate. The opposite would happen with slower productivity growth. Population growth matters because it too affects the expected return to capital. More people means more workers and output per unit of capital. For example, the opening up of China and India's labor supply to the global economy, meant a higher expected return to the global stock of capital over the past decade. That should put upward pressure on interest rates and vice versa. Finally, for a given level of expected income, a change in households time preferences means a change in their desire for present consumption over future consumption. This, in turn, affects households' decision to save and borrow. If households, say, start living more for the moment there would be less saving, more borrowing, and upward pressure on the natural interest rate.

Some like Paul Krugman and Larry Summers believe these determinants have changed enough such that the long-term nominal natural interest rate has been negative. I am not convinced and hope to explain why in a subsequent post (if you cannot wait, see my views in this twitter discussion). In my view, then, the important question is whether the short-run nominal natural interest rate has been negative since the crisis started.

So what do we know about the short-run nominal natural interest rate? It is shaped by aggregate demand shocks that create temporary deviations of the economy above or below its  full-employment level (i.e. output gaps). For example, a large negative aggregate demand shock that temporarily weakens the economy will put downward pressure on interest rates. This happens because firms do less investment spending and therefore less borrowing in anticipation of lower future profits. It also happens because households, particularly credit and liquidity constrained ones, save more and borrow less in anticipation of lower future incomes. In short, aggregate demand shocks that create output gaps will also push the short-run nominal natural interest rate in a procyclical direction. This is a natural process that allows the economy to heal itself. What is not natural is when interest rates are prevented from fully adjusting to their market-clearing levels. That happens when interest rates are pinned down at the ZLB. See this earlier post for a graphical representation of this ZLB problem.

So is this happening now? Is the short-term nominal natural interest rate negative after all these years, while actual short-term rates are at or near zero? We cannot directly observe the natural interest rate, but there is evidence of ongoing slack in the economy. And since slack--or a negative output gap--is a key determinant of the short-run natural interest rate, it is reasonable to believe the natural interest rate has been depressed over the past five years.

The figure below supports this view. It indicates that when the crisis broke there was a sharp increase in slack that is still unwinding. This figure shows the BIS ouput gap, the unemployment rate, and the NFIB's measure of small business concerns over weak sales. There is a striking correlation among these measures. The most straightforward interpretation of it is that if some shock causes firms to expect weaker (stronger) sales they decrease (increase)  production, employment, and begin operating below (above) capacity. Collectively, these firms are creating a negative (positive) output gap. Since these series all appear to be mean reverting to the lines, this suggest the shocks have only temporary effects. It seems, then, that the shocks driving this figure are largely aggregated demand shocks. 

Given the large amount of slack during the crisis, it seems reasonable that the market-clearing nominal interest rate could have turned negative during this time. This understanding is also consistent with the fact that the large run up in U.S. public debt was readily funded by investors at record low interest rates. Note that most of the investors buying the debt were individuals, their financial intermediaries, and foreigners. It was not the Fed as seen below:

 

The Fed was not the great enabler of the large budget deficits as some claim. In short, the large amount of economic slack and seemingly non-satiable, non-Fed appetite for safe U.S. treasuries all point to a depressed and maybe even negative short-term nominal natural interest rate. 

The next figure shows my crude attempt to estimate it. To do this, I first identified a period where it is generally believed that the Fed did a good job moving its target federal funds rate in line with changes in the short-run nominal natural interest rate. Following John Taylor, I chose 1984-2002 as that period. The assumption I make is that this period's ex-ante real federal funds rate is a good indicator of the short-run real natural federal funds rate. Consequently, I regressed the ex-ante real federal funds rate on measures of slack and the demand for safe assets for this period. I then plugged in more recent measures of slack and safe asset demand to estimate the current ex-ant real natural interest rate. I then added one-year inflation forecasts to this estimate to get the nominal natural interest rate that is graphed below. (More details are in footnote 1.)

 

This figure also includes Fed Chair Janet Yellen's "Balanced Growth Path" measure which can be viewed as another attempt to estimate the output market-clearing level of the nominal federal funds rate (HT Michael Darda of MKM Capital). Both measures show that the short-run nominal natural interest rate turned negative and remained there for many years. Only now does it appear to be getting close to the actual federal funds rate.

A more sophisticated attempt to measure the nominal natural interest rate was presented by Robert Barsky et al (2014) at the AEA meetings a few weeks ago.  Using a rich DSGE model, they produce the following figure. It too shows a protracted period of negative nominal natural rate values for the federal funds rate. (Note that they graph interest rates on a quarterly not annualized basis.)

Both approaches point to a sustained period of negative values for the natural nominal federal funds rate. Given the improved economic outlook, I suspect it has risen a lot over the past six months and may have even broached zero as seen in my figure above. Still, it remained negative for many years while the actual federal funds rate was pinned at zero percent. The long economic slump was the result. This begs the question of whether there was more the Fed could have done to avoid this gap between the natural and actual federal funds rate from emerging.

In my next post I will present two ways to eliminate this interest rate gap that were proposed by bloggers but never tried.   

P.S. Miles Kimball provides a nice discussion of the natural interest rate here. Also see this Bruegel Blog Review on previous blogosphere discussion of the natural interest rate.

Update: On twitter Miles Kimball mentions the importance of the risk premium on the natural interest rate. I did not discuss this explicitly in the post, but it alluded to it in my reference to safe asset demand. For a more on this issue see here.

¹For the period 1984:Q1-2002:Q4 I estimated the following equation:

  Ex-Ante Real Federal Funds Rate_t =B₀+B₁Output Gap_t-1+B₂Average Unemployment Rate Forecasted for Next Two Years_t + B₃Risk Premium_t-1+ B₄ Current Account Balance/GDP +u_t  

The first two regressors are included to measure current and expected slack. The last two regressors are used to capture demand for U.S. safe assets. The risk premium measure is Moody's BAA yield minus 10-year treasury yield. All regressors were significant and the R² was roughly 70%.