The pandemic has spurred profound changes in the global economy like a tight labor market and elevated inflation that policymakers are only beginning to understand. But one result is clear: The days of historically low interest rates are over.
R-star has risen to a range between 1.75% and 2% in our estimation, a marked increase from the 0.5% that had prevailed over the previous 15 years.
Now, policymakers are wrestling with the question of how high interest rates should be in this new economy. For guidance, the Federal Reserve looks to the long-run natural rate of interest—or the real short-term interest rate when an economy is at full strength and inflation is stable.
Known by economists as r-star, it has risen to a range between 1.75% and 2% in our estimation, a marked increase from the 0.5% that had prevailed over the previous 15 years.
R-star is not a real rate priced by markets or the Fed; rather, it’s a theoretical conceptualization that is not empirically observable.
But it has real-world impact. That’s because the Federal Reserve’s overnight funds policy rate starts with determining the level of the natural rate of interest, as the Taylor Rule outlines. (Ben Bernanke, the former Fed chairman, explained the Taylor Rule and its significance in 2015.)
An r-star estimate that has moved higher in the post-pandemic era implies a higher terminal policy rate—we think near 3%, which would be slightly higher than the Fed’s current projection for a 2.5% policy rate in the long term.
That higher terminal rate, in turn, requires lifting the inflation target as inflation remains higher than the low levels of the past two decades.
That still leaves the question of how high r-star is these days, and not everyone agrees.
Economists at the Federal Reserve Bank of New York, for example, find that the natural rate has been stuck below 2% since 2008, and is currently equal to 1.13%.
In contrast, economists at the Federal Reserve Bank of Richmond find that r-star moved above 2% in the second half of last year and was 2.2% as of the second quarter of this year.
Whatever r-star is—whether it’s the New York Fed’s estimate of 1.13%, or the Richmond Fed’s view of 2.2%, or our estimate of 1.75% to 2%—the rate has moved higher, and that is already having a significant impact on America’s real economy.
In the end, r-star plays a large role in the setting of monetary policy and how fast the economy can grow under a given set of constraints in the broader economy.
What is the natural rate of interest?
As the economist Knut Wicksell outlined in 1898, the natural rate represents the rate of interest on loans that is neutral in respect to commodity prices, and which tends neither to raise or lower them.
If the real, or inflation-adjusted, policy rate were set below this neutral, or natural, rate of interest, commodity prices would tend to increase. If above the neutral rate, then prices would decrease.
Wicksell’s analysis has had great implications for monetary policy. In the absence of a fiscal policy partner in recent decades, the Fed has had the main responsibility for maintaining price stability and the conditions for the economy’s maximum output.
In recent quarters, we have seen how expectations of monetary policy have influenced the direction of interest rates and investment. And because the trend in the short-term policy rate informs the direction of long-term interest rates, the natural rate of interest has the primary role in setting monetary policy, forming the framework for the investment-decision process.
There are two readily available models that estimate the natural rate of interest. We would like to think they encompass two different aspects of modern economic activity.
The Holsten-Laubach-Williams model
In 2001, the economists Thomas Laubach and John C. Williams of the Federal Reserve developed the Laubach-Williams model of the natural rate of interest.
They considered the natural rate to be the real short-term interest rate consistent with economic growth converging with the economy’s full potential, and with the natural rate varying over time in response to shifts in preferences and technology.
For example, potential growth during the industrialization of the 1960s and the birth of consumerism implied potential economic growth of 4.5% per year.
This 4.5% potential growth rate, estimated by the Congressional Budget Office, corresponds to a natural rate of interest of 4.5% estimated by the Laubach-Williams model. Note that we are referring to the two-sided, or smoothed, estimates of the Laubach-Williams model, which we believe best illustrates the relationship between trends in potential gross domestic product growth and the natural rate of interest.
After the rush of the 1960s, the economy’s potential growth began a decades-long decline, interrupted only by the technology advances of the 1990s.
Potential growth has since settled into a narrow range below 2% during the long recovery from the financial crisis and into what we think can be a developed economy undergoing a transition.
The implication for monetary policy has been that r-star has been stuck in a range for the past 15 years, unable to break above 2% and drifting lower from 1.3% in 2018 to 1.1% by the middle of this year.
We attribute that malaise to the bulk of productive investment having gone offshore. That left most of the domestic economy at the mercy of lower-paying employment in the service sector, while investment at near-zero interest rates was geared toward speculative behavior and stock buybacks.
Projections by the Congressional Budget Office are for potential economic growth of less than 2% over the next decade. In our view, the paucity of growth implies limited returns on investment and a deterioration of future growth.
With real rates of return at such low levels, there is little incentive to risk investment. Instead, investors will prefer holding cash, extending the duration of a stagnant economy as we saw in the case of a once-thriving Japan. Without a fiscal boost, monetary policy will be left alone to push on a string.
The Laubach-Williams model has evolved over time, starting with the original in 2003, and followed by more recent estimates that include work by the economist Kathryn Holston and are available at the New York Fed.
The model by Holston, Laubach and Williams can now be applied to other developed economies, and it includes adaptations to account for distortions during the pandemic.
The Lubik-Matthes model
Thomas Lubik and Christian Matthes of the Federal Reserve Bank of Richmond have adapted the Laubach-Williams model to respond to the economic and financial shocks that now frequently occur. This is done by allowing for changes in the model coefficients over time.
As with the Laubach-Williams model, Lubik and Matthes estimate the value of the natural rate by looking at the growth rate of real GDP, the personal consumption expenditures inflation rate, and the real interest rate. And as with the Laubach-Williams model, the Lubik-Matthes model indicates a secular decline in the natural rate from 3.5% in the early 1980s to less than 0.5% in 2013.
The Lubik-Matthes model indicates a secular decline in the natural rate from 3.5% in the early 1980s to less than 0.5% in 2013.
And as with the original work by Laubach and Williams, Lubik and Matthes stress that movements in real interest rates underlie economic decisions. When the Fed hikes its policy rate and when prices are sticky, real interest rates increase, consumption and investment decrease and the economy slows.
While not mentioned by Lubik and Matthes, the natural (real) rate of interest works to determine the direction of nominal long-term interest rates, which are the by-product of monetary policy.
As we show, the latest estimates of the natural rate by Lubik and Matthes increased to 2.2% in the second quarter of this year from 1.4% a year ago as the prospects for price stability and economic growth increased.
While it was not the intention of the Lubik-Matthes model to predict the trend in nominal interest rates, the behavior of the benchmark yield of 10-year Treasury bonds has shown a tendency to follow the estimates of natural rate. We think this is both by definition—the model includes real interest rates as one of its determinants—and as indicative of the mix of fiscal and monetary policies.
We consider the latest estimates from Lubik-Matthes as confirmation that the era of extremely low interest rates has ended and that the economy can grow again if politics and external shocks don’t get in the way.
Implications for monetary and fiscal policy
Following the lead of Wicksell, Lubik and Matthes stress that what is important for monetary policy is not necessarily the level of the natural rate, but rather its value compared to the real (inflation-adjusted) policy rate.
When the natural rate is greater than the actual value of the real, or inflation-adjusted, policy rate, you would expect prices to increase.
This accommodative monetary stance would occur in the immediate aftermath of a recession, when the policy rate is pushed lower to promote spending and investment.
Conversely, when the real policy rate is greater than the natural rate, this would lead to price declines, implying a monetary policy that was too tight and causing demand to drop.
Monetary policy was never intended to work alone. Instead, it needs to work in conjunction with fiscal policy.
This relationship would be expected to vary as the business cycle progresses from contraction to expansion, with the real policy rate converging on the natural rate.
As the business cycle matures, you would expect the Fed to begin raising its policy rate such that higher real rates would begin to cool an overheating economy and exuberance in the markets.
We normally see this at the end of business cycles when the real federal funds rate moves above the natural interest rates.
The one business cycle exception is the recovery from the Great Recession, when the real policy rate was kept negative from 2008 until 2018.
The reason for allowing this monetary policy to remain so accommodative were the multiple shocks attacking the economy’s potential growth.
There were factors including the deindustrialization of the economy, the sudden availability of cheap goods and demographic changes. In addition, there were policy shocks, including fiscal austerity, and the obstruction and uncertainly imposed by political forces.
All that resulted in an era of lower-for-longer interest rates, which in turn created limited incentives to invest domestically and a surplus of cash sloshing around the globe.
The point is that monetary policy alone is not capable of turning an economy around. Central banks need a fiscal partner to support higher rates of growth.
This is made clear by the reduction in the natural rate and the flattening of U.S. potential GDP growth. Globally, we can point to the fiscal austerity imposed on the British economy in the runup to Brexit. We can also point to Japan, where the monetary authorities kept interest rates at zero for decades but were unable to offset demographic and technological changes that afflicted the economy.
Monetary policy was never intended to work alone. Instead, it needs to work in conjunction with fiscal policy.
When the natural rate of interest drops close to zero and when the economy’s potential growth becomes stagnant, it is the responsibility of the fiscal authorities—Congress and the president—to inject money to spur economic growth.
This usually takes the form of infrastructure spending like the Interstate highway system that allows the private sector to flourish, or in research and development efforts like the space race that incentivized technological advancements.
The economy is always in transition, and it has been the government’s responsibility to facilitate that transition when necessary.
Consumers and business have prospered when government policy helps the economy take the next step.
The natural rate of interest underlies the willingness to invest and the potential growth of the economy. To move growth toward its potential, it requires both fiscal and monetary policy.
At current levels, the low level of the natural rate implies potential economic growth stuck in neutral and the need for a fiscal boost and productivity-enhancing investment to move potential growth higher.
In our estimation, investments in infrastructure, supply chain resilience, domestic manufacturing capacity and environmental sustainability are slowly moving to create the conditions to improve productivity and lift potential growth higher.
That would imply that r-star is likely now closer to 2% than the 0.5% that has prevailed over the past 15 years. For this reason, higher inflation and interest rates are likely to be part of the economic environment going forward.