The natural rate of interest depends on where you set natural real GDP
What if an economist expects the natural level of real output to be higher? How would the natural rate of interest change by expecting a lower natural rate of output?
First, I personally expect a lower natural limit upon real GDP. I see that real GDP is trending on a new normal level below the trend seen before the crisis. This graph presents my model for the interest rate as real GDP approaches the natural level of output. (The natural rate of interest is the equilibrium interest rate to keep output with stable inflation at the natural limit of real GDP.)
I see the natural level of output where capacity utilization multiplied by the employment rate is 73%. The violet and yellow lines are alternate paths that bound a zone for the Fed rate as real GDP is reaching this 73% natural level. The zone is positive at this point seen with the red dot getting close to this natural level of output (LRAS). A positive Fed rate would be prescribed. The down-sloping green line shows little spare capacity. However, the blue dot shows that the Fed rate is still on the ZLB (zero lower bound) implying that the Fed thinks the true zone is below 0%.
Now all I do in the above model is raise the demand constraint on the utilization of labor and capital (the demand constraint is the effective labor share anchor in the model). It seems many economists do not formally recognize a demand constraint. Be that as it may, I will change one variable, the demand constraint, from 73% to 78%, which would imply an unemployment rate of 5% and a capacity utilization rate of 82%. These are common enough expectations according to past data. (note: the z coefficient changes due to a change in the demand constraint.)
All that is happening here is that the monetary framework shifted right from a lower natural level of real GDP to a higher one.
The new vertical curve is based on expectations of a higher natural level of real output, like the one seen before the crisis. But what happens to the prescribed Fed rate? The violet and yellow lines, which bound a zone for the Fed rate, have both gone negative for the current level of utilized labor and capital, -0.5% and -3.0% respectively. And on balance, they would stay negative for some time yet. The green line now shows much more spare capacity, over 8%.
So if you are an economist who says there is lots of spare capacity and expects real GDP to return to the level seen before the crisis, you would recommend “pedal to the metal” aggressive monetary policy, as Paul Krugman did yesterday. You want the Fed rate to be at the ZLB for a long time, at least until unemployment sits around 5.5%, which would correspond to roughly 76% on the x-axis.
If you are like me and expect real GDP to settle into a lower natural level of output, you would recommend a tighter monetary policy. It is a safer policy to raise the interest rate when nearing the natural real GDP vertical curve.
“It is a safer policy to raise the interest rate”
What are you worried might happen if they don’t raise the interest rate?
In order to get a higher natural gdp, krugman simply announced the secular stagnations, which thus becomes the longer term cycle. So Paul wants rates set low for another eght years until we get a stimulus that reaches way back to 1980.
There is a concern that if the economy hits the natural rate with aggressively loose monetary policy, that there will be inflation tendencies. You may not see inflation in household items because consumer spending is weak, but you would probably see inflation in asset prices because capital income has tremendous liquidity.
Inflation in asset prices causes instability and greater risk of crisis in the financial markets.
Aggressive monetary policy lowers the cost of money to those who own capital. And when real GDP slows down at the natural limit, further liquidity translates into price inflation somewhere.
Remember, the Fed has a mandate to maintain price stability. That not only includes regular inflation of household items, but also inflation of assets. This is why the Fed wants to taper, because they do not want asset prices to get out of hand.
It seems that Krugman believes that in addition to the natural real GDP being higher, that pushing interest rates up prematurely will sloww the process of getting to that GDP. So it is not only the beliefs but also the model of how the economy will react to the beliefs that is important.
It still seems to me you shrug off the argument (as I interpret Dean Baker) that as the economy gets better the quality of jobs will get better. Which I would think would improve worker share.
The economy will not go into a recession until the effective demand limit is reached. That has been the story since at least 1967.
When I hear that the Fed had to keep interest rates low in 2003 to 2004 for fear of falling into a recession, it is a problem of understanding recession dynamics.
We will not fall into a recession until real GDP reaches the effective demand limit. The economy has momentum and resilience until then to absorb govt shutdowns and the like… So Krugman is wrong to think the economy might fall back into a recession. The economy is not that fragile at the moment.
And even if you slow down the increase in real GDP, that is like slowing down an airplane before landing, it is smart and safe. It is much riskier to go pedal to the metal into a landing…
And Dean Baker thinks the present is like the past. He is mistaken. The nature of jobs, bargaining power, productivity, higher natural rate of unemployment all combine to show that wages will not get better as the economy gets better.
I think I even saw a tweet from Dean or Jared Bernstein today about more working hours this last quarter but wages actually fell. The tweet said something like, more working, but being paid less.
This is the new normal, and the top economists are not getting it right.
“Remember, the Fed has a mandate to maintain price stability. That not only includes regular inflation of household items, but also inflation of assets. This is why the Fed wants to taper, because they do not want asset prices to get out of hand.”
This is quite simply wrong.
The Federal Reserve has a three part mandate: “maximum employment, stable prices, and moderate long-term interest rates.” The FOMC has issued a statement “that inflation at the rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Federal Reserve’s statutory mandate.”
In short, the stable price mandate does not apply to asset prices.
My thinking on that statement relates to the new implied mandate of financial stability as a reflection of a price mandate.
Clearly I am reading into the mandates to say that the Fed is also concerned about asset prices. Don’t you think they take asset prices seriously?
The FOMC takes a lot of things into account when forming monetary policy. But the stable price mandate does not apply to asset prices.
This may be a case where we need to look at the spirit of the law instead of the letter of the law. Since the dot.com bubble and the housing bubble, the Fed has an unspoken responsibility to keep an eye on asset prices too.
Agreed that asset prices are not in the letter of the law, but I would include it in the spirit of the law now.
I found a paper that says in the abstract… that there is evidence to support the existence of asset prices in Fed policy.
I have not read the paper yet. I will have to read it later tonight.
And Asset Pricing is a Field in Financial Economics at the Fed…
and this… “Janet Yellen, said it is central bank’s duty to watch out for unsustainable increases in asset prices and intervene if needed.”
The IMF has made it clear that loose monetary policy is not the fundamental cause of asset price bubbles (Page 106-107):
“If monetary policy were the fundamental cause of house price booms over the past decade, there would be a systematic relationship between monetary policy conditions and house price gains across economies. Certainly, average real policy rates were low and even negative in some economies, and Taylor rule residuals were mostly negative, suggesting that monetary policy was generally accommodative across economies during this period. But there is, at best, a weak association with house price developments within the euro area (Figure 3.13, blue lines).22 And there is virtually no association between the measures of monetary policy stance and house price increases in the full sample (Figure 3.13, black lines). For example, whereas Ireland and Spain had low real short-term rates and large house price rises, Australia, New Zealand, and the United Kingdom had relatively high real rates and large house price rises. Moreover, the association between measures of the monetary policy stance and real stock price growth is extremely weak, whether assessed during the global house price boom (2001:Q4–2006:Q3; not shown) or during a later period, when stock markets rallied from their troughs (2003:Q1) through the stock market declines of 2007 (Figure 3.14).
The fairly regular behavior of inflation and output and the fact that Taylor rule residuals were not associated with recent asset price rises across economies in the sample suggest that monetary policy was not the main or systematic source of the recent asset price booms.23”
Figure 3.13 is similar to the following graph from a Bernanke speech on the same subject (note the near zero coefficient of determination):
In my opinion tightening monetary policy to fight asset price bubbles is analogous to tent fumigating a house with the house’s inhabitants still inside.
It may or may not kill the infestation, but it will certainly kill the house’s inhabitants.
Thank you Mark,
Then what I understand now… is that Yellen may say the Fed has a responsibility to intervene if asset prices look unsustainable, but the Fed really does not have a beneficial effect without causing lots of instability.
Which means the Fed may try to help, but they would just make the situation worse.
Is that a good way to understand your fumigation analogy?
Since there is no systematic relationship between monetary policy and asset price bubbles, using contractionary monetary policy to intervene in asset price bubbles has to be viewed as a last choice option. It may or may not prevent the asset price bubble from growing larger.
However, contractionary monetary policy has a clear systematic negative effect on the economy. It will definitely lead to lower employment and disinflation.
I personally do not believe Yellen thinks that using contractionary monetary policy to fight asset price bubbles is a very good idea but she will not rule out its possibility.
Think of it as a sort of “nuclear option”. Failing everything else Yellen is willing to blow up the economy in order to save it. I seriously doubt this will ever come to pass.
At the conclusion of the link you gave it says this…
“However, expectations must be realistic. Even the best leading indicators of asset price busts are imperfect—in the process of trying
to reduce the probability of a dangerous bust, central banks may raise costly false alarms. Also, rigid reactions to indicators and inflexible use of policy tools will likely lead to policy mistakes.”
That paper you suggested is very good.
People may look to the Fed to react to rising house prices, let’s say, but the Fed should not be seen as the responsible entity for such a “problem”. I am seeing where you are coming from.
The Fed is having a tricky time with just inflation without a good transmission mechanism to consumers. They really don’t have a good transmission mechanism either into the asset markets, do they?
Ed, You are kind to your critics. Looking at recent inflation trends, down the last few months, and accelerating down with one negative month; then one might think we had already reached your effective limit, and had already suffered our peak inflation two quarters ago. Then the current stock peak is simply the same peak we get just before a downturn. In fact I think you are shy about calling the end on this cycle. Is this the peak?
“The Fed is having a tricky time with just inflation without a good transmission mechanism to consumers.”
Actually the FOMC’s core inflation projections have been amazingly accurate.
Consider their June projections from 2009, 2010, 2011 and 2012. Their mean error (not mean absolute error), with respect to the central tendency of their projection, for core PCEPI is +0.04 points for the same year, +0.12 points for one year out and +0.08 points for two years out.
The central tendency of their June 2013 projections are for year on year core PCEPI to be 1.25% in 2013Q4, 1.65% in 2014Q4 and 1.85% in 2015Q4. The average three year out forecast for core PCEPI over the June projections made from 2009 to 2013 is 1.58%.
Given the Fed is the institution with a price stability mandate, the FOMC’s forecasts are really targets, since if they’re not forecasting their target, they’re obviously forecasting failure. So despite the fact their official target is 2.0%, it would appear that the FOMC as a group has an implicit preference for an inflation rate of about 1.6%.
“They really don’t have a good transmission mechanism either into the asset markets, do they?”
I actually do think the US QE has had an effect on the domestic stock market. But given the history of such effects it will be temporary, and will only last as long as there is a large aggregate demand shortfall.
We have not seen the peak of the business cycle yet. No recession has started.
As real GDP goes past the effective demand limit, the theory would have it that the Fed will continue with loose monetary policy feeding money into the economy, then aggregate demand will increase with no corresponding increase in production, Then inflation would result.
There are dynamics happening now that we have not seen before… a big drop in potential real GDP, financial repression to favor owners of capital, and higher natural rate of unemployment.
Inflation can drop from price competition between firms at this point too. As the economy gets close to the effective demand limit, firms tend to crowd each other out for profits. A rise in profits for one firm means a fall for another. And with the present dynamics of weak labor, profits can be increased by lowering prices. And there isn’t the associated rise in labor share usually seen before the effective demand limit. Actually, labor share is settling into its natural level for this business cycle. I have an equation that shows where labor share will end up at the end of a business cycle. Even though labor share has dropped 5% since the crisis, the equation shows where labor share was going to stop at the effective demand limit. It is almost there now.
Data are confirming the effective demand limit… low trending real GDP, capacity utilization is constrained, unemployment staying high, stalled productivity, slow down in aggregate profits, … At the moment the most interesting thing is seeing so many economists, like Thoma, Krugman, Duy, etc… saying there is lots of spare capacity and monetary policy should be really aggressive. Yet, I am on the sidelines showing a new model that says there is not as much spare capacity as they think due to low effective demand. The data is supporting my model.
The real problems will come as they find out that there is much less spare capacity than they think. We have not seen those problems appear yet.