From Macro and Other Market Musings:
In my last
post I raised the question of whether the
nominal
natural interest rate has been negative since the crisis started. Many
observers say yes and point to it as the reason why the economic slump
has persisted for so long. For if this output market-clearing level of
the interest rate has been negative while actual interest rates have
been stuck near zero, then a general glut is the inevitable consequence.
Others find this hard to believe. Even if the natural interest rate
turned negative in 2008-2009, they question how it could remain negative
for five years.
So is the nominal natural interest rate really negative five years after
the crisis
started? To answer this question we need to first recognize there is an
entire term structure of natural interest rates. This means there is
both a long-term and short-term nominal natural interest rate. The
former is the determined by structural trends in the economy while the
latter is driven by the business cycle.
More specifically, the long-term nominal natural interest rate is
determined by trend changes in the expected productivity growth rate,
the population growth rate, and household time preferences given
well-anchored inflation expectations. Productivity matters because it
affects the expected return to capital and expected household income.
Faster productivity growth, for example, translates into a higher
expected return on capital and higher expected household incomes. In
turn, these developments should lead to less saving/more borrowing by
firms and households and put upward pressure on the natural interest
rate. The opposite would happen with slower productivity growth.
Population growth matters because it too affects the expected return to
capital. More people means more workers and output per unit of capital.
For example, the opening up of China and India's labor supply to the
global economy, meant a higher expected return to the global stock of
capital over the past decade. That should put upward pressure on
interest rates and vice versa. Finally, for a given level of expected
income, a change in households time preferences means a change in their
desire for present consumption over future consumption. This, in turn,
affects households' decision to save and borrow. If households, say,
start living more for the moment there would be less saving, more
borrowing, and upward pressure on the natural interest rate.
Some like Paul Krugman and Larry Summers
believe these determinants have changed enough such that the long-term
nominal natural interest rate has been negative. I am not convinced and hope to explain
why in a subsequent post (if you cannot wait, see my views in this twitter discussion).
In my view, then, the important question is whether the short-run
nominal natural interest rate has been negative since the crisis
started.
So what do we know about the short-run nominal natural interest rate? It is shaped by aggregate demand
shocks that create temporary deviations of the economy above or below its full-employment level (i.e. output gaps). For example, a large
negative aggregate demand shock that temporarily weakens the economy will put
downward pressure on interest rates. This happens because firms do less
investment spending and therefore less borrowing in anticipation of lower future profits. It also
happens because households, particularly credit and liquidity
constrained ones, save more and borrow less in anticipation of lower
future incomes. In short, aggregate demand shocks that create output
gaps will also push the short-run nominal natural interest rate in a procyclical
direction. This is a natural process that allows the economy to heal
itself. What is not natural is when interest rates are prevented from
fully adjusting to their market-clearing levels. That happens when interest rates are pinned down at the ZLB. See this earlier post for a graphical representation of this ZLB problem....MUCH MORE
