What’s the natural rate of interest?

Peter Olson and David Wessel write:

The natural rate of interest, also called the long-run equilibrium interest rate or neutral real rate, is the rate that would keep the economy operating at full employment and stable inflation.

You’ll find comparable statements from Paul Krugman, and here is the underlying Laubach and Williams paper, and more recently and ungated here (pdf).  Here are a variety of Brookings presentations.

Personally, I get nervous when I read about natural rates of interest, although I accept the core conclusion that currently low interest rates are not mainly the result of Fed policy.  I also find all this talk of natural rates of interest…historically strange.  A few points:

1. David Davidson and Knut Wicksell debated the natural rate of interest concept very early in the twentieth century, in Swedish I might add (see Carl Uhr’s books on Davidson and Wicksell).  Most people believe Davidson won those debates and even Wicksell seemed to concede.  Whether a given rate of interest both maintains full employment and stable inflation depends on the rate of productivity growth, for one thing.  It can be that no single rate of interest can perform both functions.

2. Keynes devoted a great deal of effort to knocking down the natural rate of interest concept (pdf), which he viewed as unforgivably Austrian.  He made the simple point — endorsed by modern Keynesians in other contexts — that the intersection with liquidity preferences at the margin shapes rates of interest, and thus there could be multiple natural rates of interest.  He also argued that in many settings there was no rate of interest whatsoever that would maintain capitalist stability.

3. In postwar economics, the Keynesians worked to keep natural rates of interest concepts out of mainstream macroeconomics.  I read Tobin as very much along the lines of Keynes.  Here is material on Hicks, Hansen, and Modigliani (pdf).

4. As Scott Sumner has pointed out, the older natural rate of interest used to truly be about price stability.  Nowadays that has morphed into “two percent inflation a year.”  Yes a definition can be changed, but still I find that intellectual maneuver strange and it implicitly suggests there may be multiple natural rates of interest; neither “zero” nor “two” is a special number.  There is also a blurring between the rate of inflation, the increase in the rate of inflation, the expected rate of price inflation, and so on.

5. Milton Friedman warned (pdf) not to assign too much importance to interest rates when thinking about monetary transmission.  On pp.10-11 he expresses his reservations about the natural rate of interest concept, which he calls the “natural” rate of interest with quotation marks:

What if the monetary authority chose the “natural” rate — either of interest or unemployment — as its target?  One problem is that it cannot know what the “natural” rate is.  Unfortunately, we have as yet devised no methods to estimate accurately and readily the natural rate of either interest or unemployment.  And the “natural” rate will itself change from time to time.  But the basic problem is that even if the monetary authority knew the “natural” rate, and attempted to peg the market rate at that level, it would not be led to a determinate policy. The “market” rate will vary from the natural rate for all sorts of reasons other than monetary policy.  If the monetary authority responds to these variations, it will set in train longer term effects that will make any monetary growth path it follows ultimately consistent with the rule of policy. The actual course of monetary growth will be analogous to a random walk, buffeted this way and that by the forces that produce temporary departures of the market rate from the natural rate.

There is still wisdom in those words.  You will note that in contrast Michael Woodford has worked to make interest rates more central to the discussion (pdf), and he is one reason why the natural rate of interest concept has made a comeback.

6. When Sraffa debated Hayek and argued the natural rate of interest was not such a meaningful concept, it seems Sraffa won.  Empirically, this Hamilton, Hatzius, Harrison, and West paper shows the natural rate can indeed be all over the place.  Here’s Carola Binder: “The more commonly reported 90% or 95% confidence interval would of course be even wider, and would certainly include both 0% and 6% in 2000.”

7. I sometimes read these days that the “natural [real] rate of interest” consistent with full employment is negative.  To me that makes no sense in a world with positive economic growth and a positive marginal productivity of capital.  It might make sense in 1942 Stalingrad, where the rate of growth was mostly negative.

Of course economic theory can change, and if the idea of a natural rate of interest makes a deserved comeback we should not oppose that development per se.  But I don’t see that these earlier conceptual objections have been rebutted, rather there is simply now a Kalman filter procedure for coming up with a number, combined with the triumph of empiricism, and in some quarters the desire to rebut the more extreme critics of the Fed.

I view the Laubach and Williams work as a highly useful “check” on the estimates of future rates of interest as contained in market prices.  (The market in fact does not seem to be crazy, relative to the model.)  But what macro properties will that likely future low interest rate world have, natural or otherwise?  There we do not know, and you will note that forecasts of inflation dynamics have not exactly been stellar, nor were most 2006 forecasts of future employment prescient.

I doubt these procedures are coming up with a “the natural rate of interest” in a meaningful form.  Or alternatively, look to Woodfordesque definitions, something like “what the rate of interest would be if prices were flexible.”  That too is a kind of (modal) forecast of interest rates, let’s not use the historical connotations of the natural rate of interest concept to smuggle in forecasts of prices and employment as well.

In any case, this is an interesting case study of how weak or previously rebutted ideas can work their way back into economics.  I don’t object to what most of the people working on this right now actually are trying to say.  Yet I see the use of the term acquiring a life of its own, and as it is morphing into common usage some appropriately modest claims are taking on an awful lot of baggage from the historical connotations of the term.  We’ve had the term “interest rate forecasting” for a while now, so let’s bring that one back into prominence.  It’s much clearer about what we are actually justified in trying to do.


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