The Fed Debates Knut Wicksell

The Federal Reserve is currently debating the natural interest rate, a concept developed by Knut Wicksell, a Swedish economist who died 90 years ago.

In today’s Wall Street Journal, Harriet Torry writes:

While Federal Reserve officials debate when to next raise short-term interest rates, they are also wrestling with the question of how high to lift them in coming years.

Signs point toward the new normal being much lower than in the past, which has broad implications for when the Fed should tighten monetary policy, how quickly, and how far.

Fed officials disagree about their likely end point, in part because they are struggling to understand why another underlying interest rate—the mysterious natural rate—has fallen in recent years. And for that many are turning to the musings of Knut Wicksell, a Swedish expert on the subject who died 90 years ago.

According to the textbooks, this so-called natural rate is the inflation-adjusted rate that’s consistent with the economy operating at its full potential, expanding without overheating. Also known as the equilibrium or neutral rate, it balances savings and investment.

The natural rate can’t be observed directly; the Fed knows it has been reached only by how the economy responds. “It’s like discovering Pluto: you can only see the effect of the gravitational pull,” said Eddy Elfenbein, an investor and blogger at the site Crossing Wall Street, comparing it to the dwarf planet whose existence was inferred from the orbits of Uranus and Neptune.

The Fed meets again this week, and they’ll update their forecasts. Within the forecasts, they’ll provide a long run outlook for interest rates which can be implied, to some degree, as to being the Fed’s estimate for the natural rate.

In March, the Fed saw long-run real rates at 1.25%. That’s below 2% which had been assumed for many years.

Most economists figured the natural rate was around 2% just before the financial crisis. Today, seven years after the recession, most estimates are around or just below zero.

“We’re seeing no pickup, none whatsoever, in the natural rate even as the economy has gotten back to full strength,” John Williams, the San Francisco Fed president who has spent years studying it, said in a recent interview with The Wall Street Journal.

This implies the central bank won’t be moving its benchmark federal-funds rate up much from its current level between 0.25% and 0.50% over the next few years. This, in turn, means lower rates for borrowers and lower returns to savers.

Policy makers are likely to leave their benchmark rate unchanged Wednesday at the conclusion of their two-day policy meeting, and could consider moving in July or September if the economy improves. They also will release Wednesday new projections for where they think the rate will rest in the long term.

No one knows where the natural rate is but we know it’s low. Very low.

“I think the current level of neutral or normal rates is pretty low,” Fed Chairwoman Janet Yellen said in Philadelphia last week. She expects it will rise over time, but said “that is something we’re uncertain about and have to find out over time.”

Economists have offered several theories for why the natural rate has fallen. Former Fed Chairman Ben Bernanke has cited a glut of savings world-wide. Harvard University economist Lawrence Summers blames ‘secular stagnation,’ or a chronic shortfall in investment demand.

Ms. Yellen has said temporary headwinds that have restrained growth since the financial crisis may be responsible, such as economic uncertainty, a strong dollar, and slower growth of productivity and the labor force.

Wicksell has been in vogue lately.

For guidance Fed officials have been revisiting the work of Mr. Wicksell, a famed Swedish economist who did much of the seminal thinking on the subject more than a hundred years ago. Speeches by senior policy makers, including Ms. Yellen, have referenced Mr. Wicksell five times in the past year alone, and Mr. Bernanke has blogged about the Swede’s ideas about the relationship between interest rates, economic growth and inflation.

Mr. Wicksell characterized the natural rate of interest as “a certain rate of interest on loans which is neutral in respect to commodity prices, and tends neither to raise nor to lower them.” But the natural rate isn’t observable and depends on “a thousand and one things which determine the current economic position of a community,” and those factors—such as productivity, unemployment, and technological and demographic change—are constantly in flux, he said.

Posted by Eddy Elfenbein on June 13th, 2016 at 10:37 am

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