Laubach & Williams do not see yet that Natural Real Rate is Rising
Yesterday a paper came out by John Williams and Thomas Laubach called, Measuring the Natural Rate of Interest Redux. They presented their model to determine the natural real rate of interest. In short, their model gives a steadily low natural real rate that would justify keeping nominal interest rates low.
Paul Krugman jumped on board and used the paper to support his views that the Fed should continue to keep the Fed rate on the zero lower bound. He said…
“Laubach and Williams find that the natural rate has plunged in recent years, and is now very, very low. The particular statistical method they use is reasonable…”
“L-W attribute the decline in the natural rate largely to the slowing of potential output, which in turn reflects demography and what looks like a slowdown in technological progress. That’s more speculative. But the low natural rate is as solid a result as anything in real time can be.”
Hold on a second, I see a problem with the statistical method. The method is not reasonable. As well, their result is not as solid as anything that can be in real time. I will compare their method to the “real time” method from my research in effective demand.
The main problem that I see is that their method is based on the trend growth rate of potential GDP. I do not agree with the CBO’s estimate of potential output. I have my own estimate based on unemployment, capacity utilization and labor share. These variables give data in real time month to month, except for labor share which is released every 3 months.
Here is a graph comparing the CBO’s potential GDP with the one that I calculate using effective demand.
The linear trend line for the CBO potential has a slope of 56.8, while the slope of my potential is 60.2. My trend line shows potential output growing faster than the CBO’s. Thus I end up calculating a higher natural real interest rate than Laubach and Williams. And if we look at the comparison just since the 1st quarter of 2014, we see an even stronger difference.
The difference in slopes is 66.78 (CBO) and 100.67 (Effective Demand). For me, the natural real interest rate is rising higher but they do not see it because their view of potential output is limited to how the CBO is adjusting it. To say that the CBO adjustments are “real time” is not correct. Their adjustments are constrained which makes them seriously lag real time.
So I will calculate a natural real interest rate using my effective demand potential output, then compare this natural real rate against figure 7 from the LW paper where different “estimates of the natural rate of interest under alternative output measures” are given. I have overlaid my line onto the graph (light blue line). My line is a 3-year average for the percentage change of the effective demand potential which I graphed above.
Through the years from 1980 to 2010, my line (light blue) tracked in range with the various estimates from Laubach and Williams. I show more potential growth during the late 1990’s which is seen by my higher natural real rate during that time.
However, the most important difference is found since the crisis. I see that the natural real rate has risen while the estimates of Laubach and Williams have trended downward. This is primarily due to the difference in how I see potential output and how the CBO sees it.
As the CBO adjusts potential downward, the natural real rate will look lower if you base it on a growth trend of potential. In fact, if the CBO adjusted potential more strongly downward, the natural real rate that Laubach and Williams calculate might go so negative that people might freak out.
However, my calculation of potential quickly adjusted downward during the crisis as seen in the next graph. My adjustment took place in “real time”.
The CBO is taking time to adjust potential downward. I adjusted it quickly. As a consequence, I now see that the natural real rate is heading upward to normal levels. Eventually Laubach and Williams will see what I see, but they have to wait for the CBO to adjust potential completely.
Laubach and Williams actually talk about the natural real rate returning to a normal level…
“The LW model assumes that the recent decline in the natural rate is permanent; that is, the natural rate will stay at historic lows for the indefinite future… but eventually the natural rate will return to a more normal level.”
Their results seem to show that there are adverse effects from the recession that are keeping the natural real rate low. Still, they expect the natural real rate to rise again. Obviously, I see the natural real rate already climbing back up toward more normal levels. They do not see it… yet.
Edward, question on your effective demand work to help me understand the above better. How is effective demand accounting for debt – public or private. So in this formula which I got over at: http://www.asymptosis.com/understanding-effective-demand-with-edward-lambert.html
Effective Demand = Real GDP x Labor Share of Income / Capacity Utilization x (1 – Unemployment Rate)
Specifically, around labor share of income. People taking on credit, or government deficit spending/ increasing spending? Do I just assume that is part of real GDP?
I have long disagreed with you on the usefulness of your effective demand measure, but have avoided debating about it. However, what you present here simply raises very serious questions about it. I do not like the concept of the natural rate to begin with, but to claim that it has risen since 2010 strikes me as being, to be frank, highly questionable. For starters, the employment rate has falled by several percents, which alone suggests the natural unemployment rate should also have fallen, just as pretty much everybody but you has argued.
That is a common question.
Effective demand has a limit. But it is not really a limit upon real GDP in the sense that real GDP will grind to a halt when it reached the limit.
The effective demand limit is upon the utilization of labor and capital as seen in the unemployment rate and capacity utilization rate respectively.
So when the economy reaches the effective demand limit, these rates stop at the limit. Unemployment usually continues to drop, while capacity utilization falls.
As for debt, debt is not income. it is money that washes through the economy as bank lending washes through the economy. It has a multiplier effect as it circulates through the economy. But the key idea here is that as the money circulates through the economy from one business to another and from businesses to employees, the money is divided by the same labor share ratio. So the over-riding effect for this money is still the labor share ratio. In effect, debt does not increase effective demand because labor share is not increased.
Labor share controls utilization of labor and capital as money circulates and circulates through the economy.
Why do people think that the natural rate of unemployment has fallen? Simple, because inflation is not appearing. They think that the labor market is still not tight enough to cause wage pressures. Phillips curve and all that. Even Laubach and Williams make adjustments in their model because inflation is not responding to the low unemployment rate. Those adjustments are part of why their model pushes the natural real rate lower.
But people are talking about how the Phillips curve is broken. Unemployment can actually drop low and the labor market get tight, but we will still not see wage inflation. The mechanisms for labor to get higher wages are dysfunctional even if the labor market is tight.
The natural real rate exists. It is an important number to think about. How much is the economy growing in real terms, productivity, capital accumulation, population and so on?
There are so many factors influencing the natural real rate that it gets confusing to pin it down. So we get estimations. I like the idea from Laubach and Williams to use the growth trend of potential real GDP. Potential moves smoother than real GDP, even in my model.
The natural real rate is the underlying real growth rate of the economy. But you will not see it through the business cycle by subtracting inflation from the Fed rate. That is because monetary policy is designed to keep the real rate lower than the natural rate until full employment is reached. That point to me is the effective demand limit. But you should only see the natural real rate at the natural level of real GDP or full-employment.
Normalization of the Fed rate means that the Fed rate will eventually reach a point where the Fed rate minus inflation gives you the natural real rate. We are still not there even according to Laubach and Williams.
Ed, we will agree here believe it or not. The labor market has tightened considerably since July 2013. Homebuilders are whining like crazy on the lack of labor and high costs. I guess it is good though, because plenty of production is in the pipeline. But the BLS is lagging.
Guys it is the Boomers. Without them as buyers now, trend growth has “slipped” to 2%. Looks like we had above trend growth between mid 2013-15. Blame Generation X, hell, everybody else does. Add 1% to every quarter since Q3 2013 and Jeb Bush slaps his forehead saying “Its the Boomers!!” “Its the Boomers”. That is GDP with the old trend.
The Fed has fallen behind the curve. Because they don’t respect demographics enough. If you don’t have the government creating a demand like with cold war spending, then you won’t have fast recoveries. Simple as that. But this recovery has matured quite a bit. Fed needs to speak in December and speak loudly about these issues.
Seriously? I would love to retire and become part of the leisure crowd; but, who can afford to do so? The answer you propose (if I understand you correctly) is far to obvious an answer to be true. Look elsewhere . . .
Plus I do not see the Labor Market that tight.
Your strongest argument in favor of your equation is to show that you predicted lower potential gdp early on , as compared to economists at CBO and elsewhere , who , frankly , should find graphs like the following humiliating :
So true Marko… that graph says a lot…