Many
people understand the “natural rate of unemployment,” and if you
don’t, you can probably guess what it is – the rate of
unemployment when the labor market reaches equilibrium. What many
people don’t know is that a similar concept exists in monetary
policy.
The
U.S. Central Bank uses its ability to adjust the short-term federal
funds rate as its primary policy tool to influence the economy. When
determining where to set the federal funds rate, the U.S. Central
Bank considers what the natural, also known as the “neutral,”
rate of interest is.
The
neutral rate of interest is unobservable, but it can be estimated
based on analysis of a variety of economic indicators. In its most
basic form, it is the short-term interest rate that would prevail
when the economy is at full employment and stable inflation. In other
words, an equilibrium rate of interest that is neither expansionary
nor contractionary. The neutral rate of interest can inform monetary
policy decisions, signaling whether the Central Bank’s interest
rate policy is stimulating or contracting the economy.
Several
Factors Driving Down the Price of Capital
In
the long run, the neutral rate of interest is determined by the
supply and demand for savings (income that is not used for immediate
consumption and is the capital that can be invested back into the
economy). The chart below compares the neutral rate of interest, the
real interest rate expected to prevail when the economy is at full
strength and inflation is stable, with the actual federal funds rate.
Current
estimates show that the federal funds rate has been higher than the
neutral rate of interest since the fourth quarter of 2017. U.S.
monetary policy as expressed by the federal funds rate is at a level
similar to the early 1960’s, which may seem to many to be geared
toward promoting economic expansion. However, when you compare
today’s federal funds rate with the neutral rate of interest, it
implies that U.S. monetary policy may actually be contractionary
right now. How can a federal funds rate at the same level be
expansionary in the 1960s, but contractionary now? The neutral rate
of interest is significantly lower today. So, why is the neutral rate
of interest at a 60-year low?
The
neutral rate of interest is at a historically low level today because
there is an excess of global savings relative to the demand for that
money for investments. Therefore, the neutral rate of interest
represents the equilibrium point, or price, for savings which is
determined by the supply of savings and the demand for investment.
Several factors impact this supply and demand dynamic.
1. Productivity and Demographics
The
current economic expansion may be the longest in the nation’s
history, but it has also been one
of the slowest expansions
in terms of cumulative growth since the start of the expansion. The
economy has expanded at an average of just 2.3 percent a year since
the recession ended in June 2009, which is well below the 3.6 percent
annual growth rate during the 1990s expansion and the 4.2 percent
growth rate in the 1980s expansion.
This
is partly because the workforce is growing more slowly. Retirements
have accelerated during the recovery, while young people have stayed
in school longer, making them less likely to work. The workforce has
grown just 0.5 percent a year, on average, for the past decade —
barely one-third the pace of its growth in the 1980s and 1990s
expansions.
Slower
productivity growth also plays a role. Low productivity growth means
businesses are less likely to seek capital for investment
opportunities. This decreases the demand for capital, so the
price of capital – interest rates – declines.
2. Secular Stagnation
Economist
Alvin Hansen coined the term secular stagnation in the 1930s,
following the Great Depression. He used it to describe a chronic lack
of investment demand relative to capital supply. In this context,
“secular” referred to the long-term nature of the stagnation.
Today, secular stagnation refers to a long period of high global
capital savings relative to low demand for capital investment. An
economy characterized by high capital savings, but low investment
demand, means the price of capital – the neutral rate of interest –
goes down.
3. Flight to safety
Our
domestic economy is more globally interconnected than ever before,
supported by a complex network of supply chains for the production of
goods and financial markets that are connected in near real-time. One
outcome of this globally connected financial market is that when
uncertainty increases globally, the demand for safe harbor assets,
like U.S. treasuries, increases. Put another way, global uncertainty
creates a flight to the safety and security of U.S. government
long-term Treasury bonds, which increases the supply of capital
domestically and drives down the neutral rate of interest.
The
neutral rate of interest is lower than the federal funds rate in the
United States, as well as in other major
economies such as Canada, Japan, and the United Kingdom.
This is not just a domestic phenomenon. For the Federal Reserve and
other central banks, low neutral rates of interest limit their
ability to respond to recessions. If the neutral rate of interest in
the U.S. were to fall further, the Federal Reserve may need to apply
tools other than the federal funds rate for expansionary monetary
policy in the event of a recession. Until then, understanding why we
have a historically low neutral rate of interest provides insight
into the Fed’s decision-making process as it calibrates the federal
funds rate – a key tool in the central bank’s toolkit.