Why The Fed’s Thinking Of Natural Rate Of Interest Is Wrong

There have been some conflicting issues with reference to the actual meaning of natural rate of interest according to some scholars and how our Fed officials are explaining it. This is well documented in a recent Wall Street Journal article. These officials are unable to relate the present economic state with the natural rate using funny expressions like “mysterious” with the term. The question is what is mysterious about the whole issue? How are Yellen and her team defining the rate? What is the basis of their definition and what is causing the miss ups? While we may not be able to answer all the questions, the term “mysterious” has been used in guiding one of its decisions surrounding its set target for Fed’s rate.

It is obvious that Fed’s thinking of natural rate is wrong and portrays their lack of proper understanding of what the concept actually means. The thought of Yellen at present is that natural rate is only meant to work for the present situation (short term). This is far from what the term really stands for; a long term rate of an economic growth side by side inflation. Natural rates are known to work for more than one economic cycle and this is what our Fed fails to understand. Both Bernanke and Yellen are defining natural rate in terms of the FFR (Fed Fund Rate). This is clearly pointed below:

While Federal Reserve officials debate when to next raise short-term interest rates, they also are wrestling with the question of how high to lift them in coming years. Signs point toward the new normal being much lower than in the past, which has broad implications for when the Fed should tighten monetary policy, how quickly, and how far. Fed officials disagree about their likely end point, in part because they are struggling to understand why another underlying interest rate—the mysterious natural rate—has fallen in recent years. And for that many are turning to the musings of Knut Wicksell, a Swedish expert on the subject who died 90 years ago (WSJ).

Are you wondering why the Fed officials are missing things up? One would think that they should have deeper understanding of these things going by their positions, but the reverse is the case here. While they are confused on the right time to increase the interest rate at short term level, they are also caught in the web of how they will increase it later. But, there is no relationship between natural interest rate and short term rates. It is believed that it cuts across all years as long as it is consistent with the current economic growth rate and able to balance between investments and savings.

The term “natural rate of interest” is synonymously used to mean neutral rate, equilibrium real interest rate and the Wicksellian interest rate. Neutral interest rate is used by some economics when such rates are employed to avoid asset speculations. Those using equilibrium real interest rate do so to explain how such rates help in keeping their economy at desirable equilibrium. Because of the impact of Wicksellian, the Swedish economist, on the definition of natural interest rate as a rate which becomes compatible with price stability level as well as stable asset price, the term became associated with his name. In a nutshell, any rate that consistently helps to maintain current economy growth within its growing rate and also stabilizing inflation is natural interest rate.

Some people even prefer using the normal interest rate for it but, that could lead to more confusion because the question will be which one is abnormal interest rate? While there may be divergent views on it, it is a type of interest rate that will neither cause a boom (over heating for the economy) nor recession (lack of demand). The aim of every monetary policy is to find that neutral or natural rate that will properly spell desirable economic growth even in the face of inflation. There is power in having a rate that is consistent with a State’s current GDP by balancing it with its level of potentials.

One of the reasons for Fed’s wrong perception is diverse models (econometric) and techniques (statistical) usually employed to arrive at the result of natural interest rate. It implies that inference has to be made from each calculation. If 10 economists are brought together, it means they will probably have different data since their decision is drawn from observed data. A closer look at different years and periods has given different natural rates. Also, despite the different estimates given by different models, the rate has remained at one point since the year 2009 with no sign of ever recovering in spite of the strength our real economy has gained ever since. Can we then conclude and join our voices with Fed that it is mysterious?

According to this article,

There are a number of problems with the conventional conception of the natural rate. It rests on abysmal ignorance of the history of economic thought. It also profoundly misconceives the relationship between the financial and real sectors of the economy. These misconceptions of the origin and essence of the natural rate lead to a monetary policy that renders wholly futile all attempts to empirically identify or “estimate” its level.

It is obvious from the forgoing that Yellen and Bernanke are disciples of Keynes and not Wicksell’s. Everyone is entitled to his or her opinions. If they are sticking with one and leaving the other, it may just be their level of understanding or a way of proving their point for not increasing the long awaited FFR. The effect of their stand is weakening investment and leading the economy downwards to deflation and other associated problems.

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