Wednesday, January 8, 2014

The Real Scandal at the Federal Reserve

Many observers have been making the case that the zero lower bound (ZLB) on nominal interest rates is the reason for the ongoing economic slump. That is, because nominal interest rates cannot go below zero--it would pay more to hold cash so no one would lend at negative interest rates--they have not been able to fall to the level needed to clear output markets. The ZLB, therefore, is acting like a price floor that is artificially propping-up short-term interest rates and, as with any binding price floor, is creating a surplus. In this case the surplus is a general glut. This price floor is preventing the Federal Reserve from spurring a robust recovery.1

Implicit in this view is the belief that the short-term market-clearing nominal interest rate is negative. Many have a hard time believing this equilibrium or 'natural rate' value of the interest rate can be negative. Others might accept that it was negative in 2008-2009, but not five years later. So is the short-term natural interest rate really negative five years after the crisis started?

The answer to this question would go a long ways in ending much confusion. If the answer is yes, then it would not be true that Fed has been 'artificially' suppressing interesting rates as many have claimed. Nor would it be true that the Fed has been enabling the large budget deficits with low financing costs for the treasury department. Finally, it would reveal that U.S. monetary policy has not been that loose despite the Fed's various QE programs.

So why has the Federal Reserve not published real-time, monthly estimates of the short-run natural interest rate? The Fed has a huge research staff, lots of resources, and is capable of providing this important information. It should be a scandal that the Federal Reserve, an interest-rate targeting central bank, does not regularly publish the natural interest rate. One cannot intelligibly talk about the stance of monetary policy for an interest-rate targeting bank without first knowing the natural interest rate level. 

It is true that estimating the natural interest rate is tricky. But the Federal Reserve could provide a range of estimates as it apparently does sometimes for the FOMC meetings (here is an example from 2005). It could also collect and provide a consensus view of the current and expected natural interest rate path from market participants. The key point is that the Federal Reserve sorely needs to start publishing at least a monthly estimates of the short-run natural interest rate. And, as long it is attempting to manipulate long-run interest rates, it should probably provide estimates of the entire term structure of natural interest rates.

Again, it is in the Fed's own interest to start doing this. Imagine, for example, how much different the tapering incident in 2013 would have unfolded if the public better undestood that natural interest rates were rising due to the improving economy. The Federal Reserve's tapering actions were merely a response to these developments. Being able to respond with more clarity about the stance of monetary policy would do wonders in muting unfounded criticisms of Fed policy. It would also make it easier to hold the Fed's feet to fire if indeed monetary policy were too loose or too tight. I hope one of Janet Yellen's first actions will be to fix this scandal.

We are still left wondering, though, if the natural interest rate really has been negative for the past five years. In my next post I will attempt to provide an answer to this question.

P.S. I have actually submitted a request (via Congress) to the Federal Reserve that it start providing this information. I am still waiting to hear back.

1Of course, all of this could be avoided if the Federal Reserve simply moved away from a short-term interest rate target. Market monetarists, for example, would have monetary authorities adjust the monetary base as needed to manage expectations in a manner consistent with hitting a NGDP level target.


  1. David,
    Excellent! You are right... The Fed should provide some communication on the natural rate of interest.
    It is not hard to determine an estimate for the natural interest rate. Here is a basic model...

    I do see that the Fed rate is low enough to push the current real rate below the natural real rate (zone of financial repression). I suspect you do too. This graph shows that the Fed rate has been in the zone of financial repression for two years. The economy is behaving like financial repression is developing.

    I look forward to your next post...

  2. So what is the natural interest rate in a deflation?