Thursday, November 19, 2015

Going All Natural at the Fed

Has the market-clearing or 'natural' short-run  interest rate been negative over the past seven years? The answer to this question would go a long ways in ending much confusion about Fed policy. If the answer is yes, then the Fed has not been 'artificially' suppressing interesting rates as many have claimed. If the answer is no, then then Fed has been keeping monetary policy too loose. In other words, one cannot use interest rates to talk about the stance of monetary policy unless one compares them to their natural rate level.

There is a problem, however, in making this comparison. The natural interest rate is not directly observable, it has to be estimated. Michael Darda, chief economist of MKM Partners, provides one estimate of it and is reproduced in the figure below. Darda's estimate illustrates how knowing both the actual interest rate and the natural interest rate allows us to think more clearly about the stance of monetary policy. It shows that the Fed was a bit too easy during the boom period (the actual interest rate was less than the natural rate) and too tight during bust period (the actual interest rate was above the natural rate). Darda's estimates also shows that the gap between the actual and natural has only slowly converged since 2009, a pattern consistent with the slow recovery from the Great Recession. Other estimates tell similar stories such as the one from Robert Barsky et al (2014) published in the American Economic Review.

While these estimates are nice, it would be immensely helpful if the Federal Reserve published its own monthly estimate 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 would be in the Fed's own best interest if it did so. Imagine if the Fed could point to a figure like the one above whenever someone accused it of artificially suppressing interest rates. It would make everyone's life much easier. 

Well, today we learned from the October 2015 FOMC minutes that this information is being produced by the board of governors staff (my bold):
The staff presented several briefings regarding the concept  of an equilibrium real interest rate—sometimes labeled the “neutral” or “natural” real interest rate, or “r*”—that can serve as a benchmark to help gauge the stance of monetary policy. Various concepts of r* were discussed. According to one definition, short-run r* is the level of the real short-term interest rate that, if obtained currently, would result in the economy operating at full employment or, in some simple models of the economy, at full employment and price stability. The staff summarized the behavior of estimates of the shortrun equilibrium real rate over recent business cycles as well as longer-run trends in real interest rates and key factors that influence those trends. Estimates derived using a variety of empirical models of the U.S. economy and a range of econometric techniques indicated that short-run r* fell sharply with the onset of the 2008–09 financial crisis and recession, quite likely to negative levels. Short-run r* was estimated to have recovered only partially and to be close to zero currently, still well below levels that prevailed during recent economic expansions when the unemployment rate was close to estimates of its longer-run normal level.
The Fed staffers are producing estimates of the short-run natural interest rate so why not share it with the public? Why not add it to Fed's collection of statistics that publishes on its website?  It sounds like the Fed has a range of estimates so it could report point estimates along with confidence intervals surrounding it. So how about it Janet Yellen? Why not go all natural at the Fed?



  1. Good point.

    I'd like to point out that the rise of rates in 2013 that has been called a "taper tantrum" looks like it was more likely a reaction to the rising natural rate. The fact that things like the taper tantrum, the Lehman failure as the cause of the late 2008 collapse, and the loose posture of the Fed in 2008 will be consensus accepted facts despite being entirely wrong gives me little hope for our ability to improve applied macro economics over time.

    1. That is why we keep blogging and doing research. No rest for the weary.

  2. David, hidden at the end of the "Natural Rate section", we read:
    "A smaller gap might increase the frequency of episodes in which policymakers would not be able to reduce the federal funds rate enough to promote a strong economic recovery and rapid return to maximum employment or to maintain price stability in the aftermath of negative shocks to aggregate demand.

    Some participants noted that it would be prudent to have additional policy tools that could be used in such situations."

  3. David, what methodology does Michael Darda use? I clicked on the link but it just went to the company website.

  4. It would be helpful if you could answer this question - Are the estimates of r* based on previous values of r (time series techniques) OR fundamental data like output gap/inflation etc. My understanding is that some methods use a mix - where the negative output gap will naturally pull down estimates of r* but residuals or smoothing techniques make it more dependent on previous values of r itself more important. thank you.

  5. From the chart, it looks as if the actual FFR was below the market clearing rate for the greater part of 3 years, but caught up in '06. Then it tracked the market clearing rate pretty closely until it bottomed out hugging 0%.

    Is there a sense that raising rates from '03 through '06 would have have forestalled and/or attenuated the ensuing crisis? And if so, by how much? In a complex economy, could this one factor be determinative?


  6. Gee, looking at the chart, it looks like the penalty for the Fed being "too loose" is mild inflation and good growth. The penalty for being "too tight" is a honking recession.