Natural doesn’t exist
A story about the natural rate of interest, a tight monetary policy and – for once – admitting that Donald Trump is right …
One of the most elusive theories of economics is about the natural rate of interest, or the equilibrium interest rate. This interest rate occurs at the point where the demand for a particular amount of money equals the supply of money, so when the economy is in perfect balance. As if this is ever the case …
The most commonly used model for determining the natural rate of interest is that of Thomas Laubach and John Williams (2003). This concerns the natural real interest rate (defined as R* by econerds). Only if we add inflation to it can we predict the interest rate a central bank should charge.
The interest rate in the United States is currently 2.5%. The question is, starting from Laubach and Williams, what the natural rate of interest should be. R* is 0.8%. And for the inflation rate I use the Core Personal Consumption Expenditures (PCE) price index of 1.6%. This makes - drum roll - natural 2.4%.
Everything depends on the input variables, and estimates are of course highly uncertain. Nevertheless, it can be stated that any increase in the policy rate will tighten the market from now on.
Painful interest rate increases
Several times in the past the interest rate increases started to bite. A graph that combines the policy interest rate and the natural interest rate makes those moments fairly clear: the emerging market crisis in the mid-1990s, the dotcom explosion around the turn of the century and in 2007 the American housing market.
The story is known, as well as the ending. In the fourth quarter of 2018, investors realised that with expected slowing growth and (too) low inflation there was no reason for new interest rate increases in 2019. The message from the market was clear. The Fed listened and made a U-turn. The central bank is no longer planning to raise official interest rates this year.
Investors even expect interest rates to decrease this year. Despite a strong growth in employment and wages, inflation remains low. The Fed currently assumes this is a temporary phenomenon. I don’t know yet.
In an earlier column I wrote about Trump’s boomerang. Maybe the US president was right at the end of April when he proposed the Fed to slash interest rates. If so, it will be the first time that he’s right about an economic matter. Trump did, however, need to escalate the trade war with China for it.