A healthy natural real interest rate… Say “No” to secular stagnation

I put together a video on the natural real interest rate. There is not one single natural real rate. It is like what Steve Waldman said…

“The word natural is always used to hide the constructed context in which an outcome occurs…”

The natural real interest rate goes lower, as policy tries to push real GDP higher. A lower natural rate is needed to promote an even higher level of borrowing for investment. Thus the natural interest rate is placed in the context of policy goals.

Larry Summers sees the natural rate as negative within the context of pushing real GDP back to the high trend that existed before the crisis. Yet, my view is that real GDP has fallen to a lower trend, and thus a healthy natural real rate would not need to be negative.

Secular stagnation involves the idea that the Fed rate will be at the zero lower bound for a long time. The model in the video shows how the Fed rate must stay at the ZLB if policy seeks to return real GDP to its natural level before the crisis. In my view, it is not wise to manipulate the economy back to the previous trend. The imagined benefits do not outweigh the certain risks.

Moreover, economists like Paul Krugman seek to make the current real interest rate lower than the natural real interest rate. The effect would be expansionary and inflationary. Real GDP would theoretically rise back to previous trend… However, real GDP is increasing slowly not because the current real rate is still too high, but because the effective demand limit is constraining utilization of capital and labor at a new lower level.

The video also covers negative real rates and inflation…


The equations for the curves are…

Natural rate of real GDP is TFUR = e

Path of nominal Fed rate = z*(T2 + e2) – (1 – z)*(T + e)

z = (2e – w + t)/(2e(e-w+1) + w(w-1))

T = TFUR, x-axis in video… e = effective labor share anchor which is the projected anchor point of labor share seen throughout business cycle… z = z coefficient, which establishes position of monetary framework… w = distance that natural interest rate crosses x-axis from LRAS curve… t = inflation target

Natural real interest rate = nominal Fed rate – inflation target

Current real interest rate = Fed funds rate – inflation

Related articles…

Krugman, Paul. On the importance of little arrows. The Conscience of a Liberal Blog. November 29, 2013.

Lambert, Edward. Natural real interest rates plus inflation targets. Youtube video. December 1, 2013. (This video is longer and includes a section on inflation targets after the 13 minute mark.)

Waldman, Steve. The negative unnatural rate of interest. Interfluidity blog. November 11, 2011.