May 20th, 2015
by Marco Del Negro, Marc Giannoni, Matthew Cocci, Sara Shahanaghi, and Micah Smith - Liberty Street Economics, Federal Reserve Bank of New York
Second post in the series. In a recent series of blog posts, the former Chairman of the Federal Reserve System, Ben Bernanke, has asked the question: "Why are interest rates so low?" (See part 1, part 2, and part 3.) He refers, of course, to the fact that the U.S. government is able to borrow at an annualized rate of around 2 percent for ten years, or around 3 percent for thirty years.
If you expect that inflation is going to be on average 2 percent over the next ten or thirty years, this implies that the U.S. government can borrow at real rates of interest between 0 and 1 percent at the ten- and thirty-year maturities. This phenomenon is by no means limited to the United States. Governments in Japan and Germany are able to borrow for ten years at nominal rates below 1 percent, and the ten-year yield on Swiss government debt is slightly negative. Why is that?
To answer this question, it is useful to consider the concept of the "natural rate of interest," introduced by Knut Wicksell in 1898 and fully integrated in modern macroeconomic models by Michael Woodford. This natural rate refers to the real interest rate consistent with full employment of labor and capital resources. More specifically, it can be viewed as the rate of interest that would obtain if all prices and wages had adjusted so as to bring the level of economic activity to its full-employment level. The natural rate of interest can vary substantially over time, as it is driven by numerous factors such as the long-run potential growth rate of the economy, demographic composition of the population, desirability of saving on the part of households, perceived profitability of investment opportunities, government spending, and taxes. Importantly, by construction, the natural rate of interest does not depend on the stance of monetary policy: when prices and wages are assumed to adjust instantaneously, economic activity fully employs all available resources, and there is little monetary policy can do to affect economic activity.
According to Wicksell, the natural rate of interest is the right benchmark for determining the extent to which monetary policy is accommodative. He argues that, "it is not a high or low rate of interest in the absolute sense which must be regarded as influencing the demand for raw materials, labour, and land or other productive resources, and so indirectly as determining the movement of prices. The causality factor is the current rate of interest on loans as compared to [the natural rate]." An implication is that monetary policy is not by itself expansionary if interest rates are low and restrictive if interest rates are high. Instead, monetary policy turns out to be expansionary if rates are below the natural rate and restrictive if rates are above the natural rate.
One key difficulty, however, is that the natural rate is not directly observable, as it is a counterfactual rate that would obtain only if all the economy's resources were fully employed. To get a sense of where the natural rate is, economists have employed various techniques. In a recent paper, Jim Hamilton, Ethan Harris, Jan Hatzius, and Kenneth West use moving averages of the actual real rate of interest over a relatively long period of time as a proxy for the natural rate of interest. The idea is that we can estimate the natural rate of interest by averaging the actual interest rate in periods when the actual rate is below the natural rate and periods when the actual rate is above the natural rate. They assess that recent estimates of the real rate are low as a result of temporary headwinds on investment, deleveraging, and so on, but that the long-run equilibrium U.S. real interest rate remains significantly positive. While the measure provided by these authors is very useful to understand low frequency changes in the actual real rate of interest, it arguably does not correspond to the Wicksellian notion of the natural rate. As Paul Krugman points out in a recent blog post, when monetary policy is constrained (by, for example, the zero lower bound) the actual and natural rates may not coincide, and if the constraint binds for a long time, the difference between the two can be quite persistent. The practical implication is that this long-run measure of the effective real rate cannot be used to assess the stance of monetary policy in those instances.
Another approach, proposed by Thomas Laubach and John C. Williams, involves estimating a statistical model linking real GDP, inflation, and a short-term interest rate, and assuming that the gap between real GDP and its long-run trend depends on the past gaps between the actual interest rate and the natural rate. This model allows one to disentangle movements in the natural rate driven by long-run growth considerations from those driven by cyclical considerations. However, the estimated measure is best suited for a longer-run measure of the natural rate of interest, as discussed more recently in an article by San Francisco Fed President Williams.
DSGE models, such as the New York Fed's DSGE model, provide an alternative approach for estimating the natural rate of interest by imposing on the relationships among economic variables a structure informed by modern economic theory. This model, which builds on the model with financial frictions used in Del Negro, Giannoni, and Schorfheide (2015), is estimated using data on real GDP, consumption, investment, hours worked, real wages, two distinct measures of inflation (the GDP deflator and core PCE inflation), the federal funds rate, and the ten-year Treasury yield. We also use survey-based long-run inflation expectations to capture information about the public's perception of the Fed's inflation objective, and market data on expectations of future federal funds rates to incorporate the effects of forward guidance on the policy rate. Finally, the model allows for persistent shocks to both the level and the growth rate of productivity, in an attempt to allow for the possibility of secular stagnation, and uses data on the growth rate of productivity. We discuss the model's forecasts in the first post of the series.
Having a model makes it possible to define, and compute, the Wicksellian notions of "full employment" output and interest rates, precisely because we can construct a counterfactual economy. Specifically, we construct the natural rate as the equilibrium interest rate that would obtain if prices and wages were perfectly flexible (so that output and employment would be at their "potential"), if there were no shocks to the markup on goods and labor markets, and no financial frictions. Robert Barsky, Alejandro Justiniano, and Leonardo Melosi have used a similar model to estimate the natural rate of interest.
The red line in the chart below shows the model's estimate of the nominalnatural rate of interest (that is, the sum of the real natural rate of interest and expected inflation) along with its forecast. For comparison, the chart also shows the recent evolution of the nominal federal funds rate (solid blue line).
The chart shows that the estimated quarterly natural rate of interest is quite volatile in the short run, mostly because of fluctuations in quarterly consumption. As these short-term fluctuations are averaged out (right-hand panel), the estimated natural rate paints a fairly consistent picture: The natural rate fell sharply during the crisis, from above 6 percent in early 2007 to about -2 percent in mid-2009. The natural rate was slightly above the actual rate for the period preceding the Great Recession, and well below it for the entire post-Recession period, indicating that the zero lower bound imposed a constraint on interest rate policy. The natural rate is currently close to, but still below, the actual rate, suggesting that policy is not particularly accommodative. Finally, the natural rate is projected to increase in the near future, since the factors that brought down the natural rate during the crisis are dissipating, as discussed in our first post.
What are the factors that have led to such a precipitous drop in the natural rate and that have kept the rate at such a low level? The DSGE model allows us to trace the evolution of the natural rate back to the original shocks perturbing the economy. The next chart shows the real natural rate of interest, in deviations from its long-run mean. The colored bars show the contribution of various shocks to the evolution of the natural rate.
The dark blue bars refer to household "discount factor" shocks, that is, to disturbances to the household's willingness to consume or save. The chart shows that while in 2007, households appeared more willing than normal to consume, they have since reversed this tendency by saving more than usual. This factor boosted the real natural rate above its long-run average by 2 percentage points in early 2007 and depressed the rate by about 1 ½ percentage points in 2012-13. The light blue bars refer to shocks in firms' willingness to invest in physical capital. The chart reveals that in 2007 and 2008, firms were very willing to invest. However, since 2009, they have been much more prudent, which contributed to lowering the natural rate by more than one percentage point. These effects are projected to abate slowly as consumers are able and willing to consume more again and firms are projected to invest more. Changes in total factor productivity are also responsible for large drops in the natural rate, from 2008 to late 2014, as the orange bars show. Finally, other aggregate demand factors, such as government expenditures, have pushed up the natural rate in late 2008 but have exerted a downward pressure on rates since then.
Several factors are missing from the analysis. For instance, a potentially important omission relates to the assumption of a closed economy. Properly accounting for international factors would likely result in a different estimate of the natural rate. Explanations pertaining to the "global saving glut" advanced by Ben Bernanke suggest that foreign saving might push the natural rate of interest to even lower levels than estimated here.
In conclusion, the low level of interest rates experienced since 2008 is largely attributable to a reduction in the natural rate of interest, which reflects cautious behavior on the part of households and firms. Monetary policy has largely accommodated the decline in the natural rate of interest, in order to mitigate the adverse effects of the crisis, but the zero lower bound on interest rates has imposed a constraint on the ability of interest rate policy to stabilize the economy. Looking ahead, we expect these headwinds to continue to abate, and the natural rate of interest to return closer to historical levels.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
About the Authors
Marco Del Negro is an assistant vice president in the Federal Reserve Bank of New York's Research and Statistics Group.
Marc Giannoni is an assistant vice president in the Bank's Research and Statistics Group.
Matt Cocci is a senior research analyst in the Bank's Research and Statistics Group.
Sara Shahanaghi is a senior research analyst in the Bank's Research and Statistics Group.
Micah Smith is a senior research analyst in the Bank's Research and Statistics Group.