Wish upon a y-star
Central bankers meet this weekend to discuss r* and π* — interest rates and inflation targets. But it is y* — potential growth — that points true north. (Wonky)
Central banks official gather in Jackson Hole this weekend to look at the stars. At the center of discussions will be the idea that equilibrium interest rates (r*) are low, at least by historical standards. This is the interest rate that should prevail when GDP growth is at its equilibrium level (y*) and inflation is right on the central banks’ target (π*).
You might wonder what is the point of discussing equilibrium levels, when the economy seems to be always out of whack. But even when unreachable, the stars are a useful guide.
John Williams, head of the San Francisco Fed, has argued in a recent note that since r* has settled on a lower orbit, monetary policy needs to adapt — perhaps by setting π* higher. The underlying rationale is that if the “natural” rate of interest is lower than it used to be, then the Fed’s own policy rate will also be lower, and closer to zero.
The central bank might more often run into the “zero lower bound problem”: when even lowering the policy rate all the way to zero is not enough to stimulate an economic recovery. This, Williams argues, could imply that deeper and longer recessions followed by slower and weaker recoveries will become the norm. In this new world, monetary policy must rethink its targets: Williams suggests a higher inflation target or a nominal GDP target.
But what really matters for the economy…is the real rate of interest — the nominal interest rate minus the inflation rate. This is obvious, but worth keeping in mind, as we routinely discuss nominal rates like the Fed’s policy rate (Fed funds) or nominal yields on government bonds.
There is a broad consensus that the natural real rate of interest has declined — but why?
The debate focuses on the interest rate on safe assets — government bonds. This is driven by:
- Factors linked to the rate of growth of the economy, such as productivity. Since an alternative to investing in government bonds is investing in the real economy, a stronger economy goes hand in hand with a higher natural real interest rate — and vice-versa.
- Other factors driving the demand and supply of safe assets — since demand and supply determine price, and the interest rate is inversely related to the price.
Three forces have driven the natural interest rate lower:
- Potential growth has declined since the last recession;
- Emerging Markets have increased their savings, primarily in the form of reserves of central banks and sovereign wealth funds; these have preferred to invest in safe assets, driving up demand (Bernanke’s “savings glut” );
- Major central banks have bought massive amounts of government bonds through Quantitative Easing, boosting demand for safe assets.
So which star shows us the true north? To me, the most important is y* — the potential rate of growth of the economy. The key problem is that potential growth has declined, to 1.8–2.0% in the Fed’s own estimates. — depressingly lower than the 3.3% growth rate averaged during 1950–2006.
Would the monetary policy response be more effective if the Fed targeted a higher inflation rate?
The Fed now targets 2% inflation, and expects that the long-run policy rate will be about 3%, implying a real policy rate of 1%. If the Fed stabilized inflation at, say, 4%, it could keep the nominal policy rate at 5%. When a recession occurs, the Fed would then be able to cut the policy rate by 5 percentage points rather than 3 before hitting the zero bound. For a given decline in the inflation rate, a bigger move in the nominal policy rate will deliver a bigger cut in the real rate and therefore a stronger stimulus.
But then why have central banks set the inflation target at 2% in the first place?
The Fed says that it “is most consistent over the longer run with the Federal Reserve’s mandate for price stability and maximum employment”. Higher inflation is more volatile, makes it harder to take business and financial planning decisions, and can cause distortions as some prices adjust faster than others. It is likely to be harder to keep inflation stable and inflation expectations anchored at 4% than at 2%.
Is this a price worth paying? We have not tried it before, so it is a difficult call to make. My concern is that we are taking for granted the credibility that the Fed has for controlling inflation — a credibility earned at a high economic price in the 1980s. Raising the inflation target could put it at risk.
Moreover, if higher inflation is more volatile, the same recessionary shock could cause inflation to fall further from a 4% level than from a 2% level; and that would negate the benefit of starting from a higher nominal interest rate.
We should focus on lifting y* — the long-term growth rate of the economy.
This calls for more investment, including in R&D, better infrastructure, more education (measures mentioned in Williams’ note) as well as tax reform and lean targeted regulations. These measures do not fall under the central bank’s purview, but they are the important ones now.
Some argue that accommodative monetary policy can help lift potential growth by fueling stronger investment — this is plausible in principle, but does not seem to be happening now.
Stronger potential growth would raise r*. Meanwhile the other forces that have reduced the natural rate of interest are set to abate or reverse.
In Emerging Markets, stronger social safety nets and gradually developing financial markets should slow savings; the normalization of monetary policies will eventually reduce central bank demand for safe assets. Together with the acceleration in investment that would follow in a better business environment, these changes would tilt demand away from safe assets.
Bottom-line: we should not assume that interest rates will be lower forever.
Some of the forces behind the savings glut are already abating or reversing. Boosting potential growth would then take us back to a situation where we can safely target 2% inflation, and enjoy price stability, full employment and faster growth in living standards.
Raising the inflation target, or shifting to a nominal GDP target, would then be a backward-looking response carrying unnecessary risks. Measures to raise y* are a lot more urgent and important.
