Tuesday, December 20, 2011

Bill Gross Forgets About the Natural Interest Rate

Like Paul Krugman, I am am puzzled by Bill Gross' Op-Ed in the Financial Times.  Gross argues that the low interest rates of the Federal Reserve are causing the financial system to deleverage.  Thus, he concludes that Fed policy is actually hampering the recovery of the U.S. economy.  Now I agree with Gross that Fed policy is hampering the recovery, but it is not because monetary policy has been too loose.  Rather, it has been too tight.   

What Gross fails to consider is that interest rates would be low now even if there were no Fed. This is because the economy is weak and as a result the natural interest--the interest rate consistent with economic fundamentals--is low.  As I constantly tell my students, never draw any conclusions about the stance of monetary policy by looking just at the target policy interest rate.  Instead, I tell them, look at the policy interest rate relative to the natural interest rate over the entire term structure.  Given the large output gap and the economic uncertainty, the natural interest rate is currently low and may even be lower than the actual federal funds rate.  

Now this discussion should not be a surprise for Bill Gross.  PIMCO previously published a nice piece by Paul McCulley and Ramin Toloui on the neutral interest rate--another way of saying the natural interest rate--back in 2008 that argued the Fed may be slow to act and thus end up chasing down the neutral interest rate without ever getting to it.  Here is an excerpt:
If the central bank does not act quickly enough – and financial conditions deteriorate further – the central bank may end up just chasing the neutral rate down without ever reaching the level needed to provide monetary stimulus to the economy.
In short, even though the Fed may lower its policy interest rate monetary policy may still be tight.  And that is exactly how I view the current situation.  By failing to prevent the collapse of aggregate demand  in late 2008 and having failed to restore it to since then, the Fed has passively tightened monetary policy.  This passive tightening of monetary policy is the reason for the sluggish economy and the low interest rates.  The financial deleveraging that has Bill Gross so worked up is therefore the result of tight monetary policy, not loose.  If Gross really wants to stop the deleveraging then he needs to be calling for something like a nominal GDP level target.

Update: John Carney and David Glasner make similar observations.


  1. Bill Gross seems to have slipped a nut lately. He's a nice guy, and shrewd and careful. But I think he has made several bad forecasts of late, and rather than trying to understand the market, he is blaming the Fed.

    Gross just does not understand chronically low interest rates. He should think about Japan. He should think about global capital gluts. He should think about weak demand. He should think about zero bound.

    I am beginning to think that certain people (old fogies like myself) often just cannot adjust to a changing world. The old shibboleths keep coming back---the need to fight inflation, hold the line on foreign aggressors, or fight hunger and racism in the USA.

    But I look around and see very low inflation, no military threats whatsoever, a nation of fat people, an integrated society and the NFL, NBA, the music industry dominated by minorities cheered lustily by largely white audiences.

    Sure, there will always be some threat from inflation, some foreign despots, some hunger and some racism. But our policies have to reflect reality.

  2. David,
    "What Gross fails to consider is that interest rates would be low now even if there were no Fed."

    I think Gross is saying the term premium would be higher in the absence of financial repression. The low current premium reduces the incentive for maturity transformation, which in turn reduces the volume of financial intermediation and velocity. I suppose he is also making a second point that, with real returns to savers negative, their incentive to fund shadow bank liabilities is also low. This, however, merely follows from the flat yield curve (as shadow banks can offer only a meager premium over insured deposits).

  3. David,

    Yes, the term premium is probably lower but is it because of 'financial repression' or because of a flight to quality? I also suspect that an important reason that long-term rates are depressed is that expected short-term interest rates are low because expected economic growth is weak.

    Thus, the lack of financial intermediation may have very little to do with financial repression.

  4. David,
    "short-term interest rates are low because expected economic growth is weak"

    What measure are you using for expected growth? Economists' seem to be forecasting around 4% NGDP growth. TIPS spreads and corporate earnings growth forecasts also point to a continuation of the modest recovery in NGDP. IMO, these market expectations do not "fit" with a 5-yr yield of 0.90%.
    Finanical repression is a plausible explanation for this divergence.

    If we had no financial repression and weak growth expectations, I would argue nominal rates would be low and inflation expectations would be negative -- just as in Japan.

  5. David P.,

    4% expected NGDP growth is weak since it does nothing to close the output gap or noticeably make a dent in unemployment--all it does is maintain the slump. A modest recovery in nominal spending does not cut it when a robust recovery is needed.

    But that is only half of my point. I also mentioned the flight to quality. I am putting up a post soon that further elaborates.