Quick Recap Of The Natural Rate Of Interest

The "output gap" is a measure of whether the economy is full capacity or not. If the output gap is positive, the economy is assumed to be growing faster than "potential," and so there should be upward pressure on inflation ("all else equal"). The output gap cannot be directly measured, but it is typically assumed to be the difference between current GDP and a state variable "potential GDP," which can then be estimated using some technique. It should also be correlated with directly measured variables, such as the unemployment rate, industrial capacity utilisation. Correspondingly, the implied "output gap" calculated by a model can be compared to economic data, and one can debate whether or not the reading makes sense. Expectations variables, such as inflation expectations and interest rate expectations. These can be taken from fixed income markets (assuming that we can deal with various risk premia embedded in fixed income pricing) or surveys. As a result, these variables can be treated as directly measured. The natural (real) rate of interest. If the real policy rate is above the natural rate, it is assumed that economic growth will tend to decelerate. (Note: a real interest rate is the quoted rate of interest -- the nominal rate -- less some measure of inflation.) We cannot directly measure the natural rate of interest, but it can be inferred from a model. We can think of the process as follows (I am simplifying somewhat). The model will generate an expected level of economic growth based on other variables, and this expected growth level is compared to measured growth in the economy. If real world growth is slower than expected, then the deviation of the actual real rate from the natural rate is higher than expected. This leads us to revise lower the estimate of the natural rate of interest. (The simplification I have made is that we are just adjusting the estimate of the natural rate of interest, and leaving other estimated variables fixed; in practice, all state variable estimates will be updated simultaneously.)

The role of the natural rate of interest is what leads to my argument that mainstream macro is non-falsifiable. As noted above, we could look at the estimate of the output gap, and we could reject it based on how is compares to other economic data that are measuring aspects of capacity utilisation. Meanwhile, expectations variables are pretty much directly observed, although we need to account for biases. The problem is the natural rate. There is no reason to believe that it should be any particular value at any given time, and so there is no way of rejecting the estimates.

A Recent Analysis Example

The recently published paper " Why So Slow? A Gradual Return for Interest Rates ", by Vasco Cúrdia discusses the recent trends in the estimates of the natural rate of interest, illustrating the problem. The paper is quite straightforward, and the author helpfully provides the time series of his central estimate of the natural rate of interest (depicted below). As seen in the chart in the linked article, he also shows that the estimate has a quite wide uncertainty band around the central estimate. (Since I do not wish to be distracted by the discussion of the uncertainty of the estimate, I just show the central estimate.)





What the chart shows is that the estimate was near historical conventional estimates of the real natural rate (above 2%), but then dropped like a rock below -2.5%. Since nominal rates cannot go below zero and inflation has been low and stable (1-2%), it is impossible for the actual policy rate to be below the natural rate of interest. This has led to well-known anguish amongst New Keynesian economists.



It must be kept in mind that this was largely not predicted. Before 2007, the standard argument amongst New Keynesian economists was that the 1970s inflation was the result of the central bank keeping the real policy rate negative for a period of time. Since the natural rate is allegedly based on the optimising choices of a representative household, and negative time preferences make little sense, a so negative policy rate should obviously be stimulative. This caused the consensus expectation of a rapid recovery fuelled by extremely stimulative monetary policy. As anyone who was short duration from 2010 on could tell you, the recovery was anything but rapid. It was only in retrospect that the estimated natural rate was revised lower.





Beyond 2015q3, the time series is an projection based on the model dynamics. Since whatever has driven the natural rate of interest to be negative is assumed to be temporary, the natural rate reverts back to some long-term "normal" level. (The model incorrectly predicted such a reversion throughout the entire negative natural rates period.)





Although it appears that a low natural rate of interest "predicts" the current environment of disappointing growth, in reality it is just the result of the model adjusting state variables to compensate for historical prediction errors. Regardless of what the level of the policy rate is, during a period of slow growth, it will always be above the estimate of the natural rate. (I have not attempted to replicate the methodology, but I assume that if the real policy rate was held at 3% and other inputs held unchanged, the estimate of natural rate of interest would be somewhere just below 3%.)





Zero Hedge and get much more entertaining stories explaining economic outcomes. But in order to predict the future, we need to forecast the natural rate interest. Since we have no way of making such predictions, the models are broadly useless as forecasting tools. This uselessness calls into question the "scientific" basis of modern macro; generally speaking, The DSGE methodology does not really offer useful predictions about the economy. The models can be used in "back-casting" -- explaining what happened historically. However, we could readand get much more entertaining stories explaining economic outcomes. But in order to predict the future, we need to forecast the natural rate interest. Since we have no way of making such predictions, the models are broadly useless as forecasting tools. This uselessness calls into question the "scientific" basis of modern macro; generally speaking, science avoids the use of non-falsifiable models

Concluding Remarks

The "natural rate of interest" is an analytical concept which is embedded in mainstream approaches to economics. Modern Dynamic Stochastic General Equilibrium (DSGE) models are built around the importance of interest rate (including expected interest rates) and the central bank's setting of those rates. If you are willing to assume that mainstream macro is correct, it provides a way of looking at the world. For example, "secular stagnation" (slow growth) can be blamed upon the natural real rate of interest falling to a negative value, leaving central banks unable to stimulate the economy.However, if you are less willing to assume that mainstream macro is correct, and would like to test the efficacy of interest rates for steering the economy, you will run into a severe problem. The way that the natural rate of interest is currently conceptualised means that it can explain anyeconomic outcome; that is, it is non-falsifiable. As a result, there is no point in trying to prove modern mainstream macro as being incorrect; that task is impossible. The only way forward is to ask whether modern macro can make an useful predictions (as opposed to fitting historical data); I would argue that there is little sign of any such predictive power.The concept of the natural rate of interest has a long history, and I do not wish to attempt to summarise it here. I will only give a rough outline of how it appears in modern "New Keynesian" economic models. (And since there are thousands of such models being churned out by academics and central bank researchers, one must keep in mind that any generalisation about such models is difficult.)Standard New Keynesian DSGE models are driven by a few state variables, many of which are not directly observed.To be fair to Vasco Cúrdia, his paper does not delve into such metaphysical debates; instead he is dealing with other topics that are of extreme interest to fixed income analysts. To summarise, he is providing justification for an extremely gradual pace of policy rate renormalisation. This should be of interest to any bond bulls out there. I seriously doubt that Cúrdia even thought that readers might question the importance of interest rates in determining economic outcomes, and so there is no material which responds to my criticisms here.Given the lack of hard evidence either way, the question of how important interest rates are for steering the economy is largely a question personal beliefs, such as the choice of a favourite sports team. The advantage of post-Keynesian economics is that there is an openness to question the role of interest rates; within the mainstream, the answer is assumed and methodologies are locked in the grip of circular logic.(c) Brian Romanchuk 2015