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.