The future of monetary policy is troubling. I present a video to explain. (Part 4 of a series on the journey of the Fed rate from 1978 to the present.)
Since the 1960’s, the Fed rate has consistently reacted to the natural level of real GDP (in terms of labor and capital utilization). Effective demand sets the natural level. The natural level of real GDP has fallen since the crisis. Monetary policy so far does not recognize this. This graph from the video shows how the natural level of real GDP is determined.
There are 3 red trend lines. The point where each trend line crosses the x-axis sets the natural level of real GDP (in terms of labor and capital utilization). The trend line on the right is from the 1970’s to 2003. The trend line in the center is from 2003 to the crisis. The trend line on the left points to the current natural level of real GDP. The Fed funds rate has recognized and responded to these levels consistently over the years. The trend line shifts with core shifts in labor share.
A problem is that the Fed along with other economists, like Paul Krugman and Larry Summers, still see a large output gap to bring the economy back to full employment. In effect, they still see the economy returning to the middle trend line above, but with a negative real rate to get us there. As Larry Summers said yesterday, “Indeed, US real rates are substantially negative at a five year horizon.”
The natural real interest rate at full employment is roughly determined by adding productivity growth, population growth and a time preference variable. As people put off consumption into the future, the time preference variable declines. Productivity growth is low, population growth is low and people are preferring to consume less currently. So it might seem reasonable that the natural real interest rate has fallen from its historic range of around 3%.
But has the natural real interest rate gone negative? No… It should be positive when the natural level of real GDP is reached in about a year, but not quite as high as 3%. In the video, I say 1.5%. Pimco said that the Fed forecasts reaching its target with a 2% natural real rate by 2019! Well, we won’t have to wait that long.
Note: In the video, I say there is price stabilization when the natural real interest rate and the current real interest rate curves cross under the Fed rate. This concept is related to the neutral real interest rate, which is defined as monetary policy which is neither expansionary nor contractionary. (Bernhardsen 2007, Wu 2005)
Bernhardsen, Tom, Karsten Gerdrup. The Neutral Real Interest Rate. Monetary Policy Department, Norges Bank. 2007.
Escolano, Julio, Anna Shabunina and Jaejoon Woo. The Puzzle of Persistently Negative Interest Rate-Growth Differentials: Financial Repression or Income Catch-up? IMF working paper. November 2011.
Collignon, Stefan. Implications of the Low Interest Rate Environment for the Real Economy. European Parliament. Draft paper. February 2013.
Summers, Lawrence. Why stagnation might prove to be the new normal. larrysummers.com. December 15, 2013.
Wu, Tao. Estimating the “Neutral” Real Interest Rate in Real Time. Federal Reserve Bank of San Francisco. October 2005.