This is the third of four articles examining monetary and fiscal policy and the Federal Reserve’s response to the most significant issues of today’s economy. The first article examines the Fed’s challenge in meeting its mandate for full employment. The second looks at the Fed’s other mandate, for price stability. This article discusses the natural rate of interest and its impact on Fed policy. The last examines the reflation of the economy and the risks that remain.
The Taylor Rule is a long-established equation that models the Federal Reserve’s interest rates based on employment rates and inflation. It’s an important part of the Fed’s deliberations as it seeks to achieve its dual mandate of full employment and price stability.
The natural rate of interest, or r-star, forms the basis for setting the Fed’s overnight policy rate and, by extension, interest rates across all maturities.
But there is a tendency among policymakers to overlook another part of that equation as the Fed grapples with setting its policy rate: the equilibrium, or natural, rate of interest.
In our estimation this is unfortunate and needs to be amended as the Fed attempts to maintain a growing economy and stable prices.
Known as r*, or r-star, the natural rate of interest forms the basis for setting the Fed’s overnight policy rate and, by extension, interest rates across all maturities.
To be sure, any estimate is fraught with difficulty and always subject to interpretation. Yet given policy challenges over the two or more years that it will take to restore price stability, this cannot be ignored.
Based on our research, we estimate that r-star is roughly around 0.5%, or lower, which would put a ceiling of 2.5% on the terminal policy rate should the Fed maintain its 2% inflation rate target during the current business cycle. But that may prove difficult given the elevated inflation.
Should high inflation continue, the Fed may want to consider resetting the inflation target to 3%, which would carve out more room to address persistent inflation concerns and further room to fight recessions.
That would, in our estimation, prove far more preferable than a premature curtailment of the current business cycle.
In a 2001 paper, the economists Thomas Laubach and John Williams, then of the San Francisco Federal Reserve Bank, defined the natural rate of interest as “the real short-term interest rate consistent with output converging to potential, where potential is the level of output consistent with stable inflation.” They note that r-star “represents a medium-run real rate ‘anchor’ for monetary policy and corresponds to the intercept term in feedback rules such as Taylor’s.”
R-star and business investments
The concept of r-star can be thought of as comparable to the minimum return on investment, which is the starting point for every business decision-making process. As such, r-star is the bare-bones policy rate that would be consistent with stable rates of economic growth and inflation.
We estimate that r-star is roughly around 0.5%, or lower, which would put a ceiling of 2.5% on the terminal policy rate.
Under normal circumstances, the rule of thumb was that r-star was equal to roughly 2%. When combined with a normal 2% level of inflation, the Fed’s policy rate would be 4%.
Laubach and Williams, along with the economist Kathryn Holston, have modeled estimates of the natural rate of interest for an economy at full strength and with stable inflation. Because of changes in technology and changes in comparative advantage relative to our trading partners, we would expect those estimates to change over time.
We would point to the secular decline in real gross domestic product growth as an example of those changes. During the primacy of the U.S. economy, the 10-year average of real GDP growth was 4.7% a year in 1969. That slipped to 3.4% in 2000 before falling to 1.5% before the 2018 trade war.
Compare that to Holston-Laubach-Williams estimates of r-star, which dropped from 4.5% in the 1960s to less than 1% before the pandemic. This decline is consistent with the market-based estimates of real, or inflation-adjusted, short-term and long-term real interest rates.
The secular decline in real gross domestic product is not something that can be wished away. Rather, the decades of slowing growth suggest an economy no longer able to support high real interest rate levels.
There are other reasons for the decline in r-star. A 2018 paper by Michael Ng and David Wessel published by the Brookings Institution points to increases in productivity that have suppressed the demand for capital. They also cited the savings glut and increased risk aversion after the financial crisis and an aging demographic, all of which have worked to pressure interest rates lower,
In terms of monetary policy, r-star is not something that can be set by the Federal Reserve. Instead, r-star has to be lived with. This is particularly evident when the Fed has so little room in its policy rate to encourage borrowing or lending.
The decline in r-star suggests that changes in Fed policy are likely to be incremental moves of low interest rates for a long time.
For businesses considering capital investment, that implies that despite the ups and downs of inflation and labor force availability, the cost of making investments will remain cheap for some time even as the Fed moves to normalize interest rates away from the zero bound.
We can see this in the implied real federal funds rate, which we have estimated by subtracting the Federal Open Market Committee’s predictions for long-term inflation from their predictions for the long-term target of the nominal funds rate. That implies an r-star equal to 0.5%, a sober reminder of the need for fiscal stimulus and increases in the productivity.
The takeaway
Key policy decisions on the setting of the federal funds rate need to be explained to the professional investment and managerial community within a context that takes into consideration the appropriate level of r-star.
Shocks to the economy caused by the pandemic will linger well into the next business cycle similar to those that occurred during the financial crisis and are still felt today. Given those shocks, long-term demographic changes, the relatively weak rate of return on investments and other factors, both the real and nominal rates of interest cannot move too far above our estimation of r-star without posing an unacceptable level of risk to the real economy.
