It is widely accepted that by means of suitable monetary policies the US central bank can navigate the economy towards a growth path of economic stability and prosperity. The key ingredient in achieving this is price stability.
Some experts are of the view that what prevents the attainment of price stability are the fluctuations of the federal funds rate around the neutral rate of interest also known as the natural rate.
The neutral rate, it is held, is one that is consistent with stable prices and a balanced economy. What is required is that Fed policy makers successfully target the federal funds rate towards the neutral interest rate.
Once the Fed brings the federal funds rate in line with the neutral interest rate, price stability and thus economic stability can be reached, so it is held.
Recently some officials at the Fed have adopted a view that the natural rate is currently very low, and that its decline may reflect a loss of economic potential. If this way of thinking is valid then there are immediate implications for the Fed: a low natural rate means the Fed could not move its short-term federal funds rate very high before policy becomes too tight.
On Wednesday Oct 5, 2016 speaking to a central banking seminar in New York, the Fed’s vice Chairman Stanley Fischer said that he was concerned that changes in global savings and investment patterns may have driven down the natural rate. As a result he said “we could be stuck in a new longer-run equilibrium characterized by sluggish growth.”
This framework of thinking, which has its origins in the 18th century writings of the British economist Henry Thornton[1], was articulated in late 19th century by the Swedish economist Knut Wicksell.
It is safe to suggest that the current framework of central bank operations throughout the world is based to a large degree on Wicksellian writings.
Knut Wicksell’s framework for price stability
The central element in Wicksell’s framework is the natural interest rate, which Wicksell defined as “A certain rate of interest on loans which is neutral in respect to commodity prices, and tend neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital”.[2]
The natural interest rate is defined as the rate at which the demand for physical loan capital coincides with the supply of savings expressed in physical magnitudes.[3]
In his framework Wicksell makes a clear distinction between the interest rate that is determined in financial markets and the interest rate that is set in the real world without money.
Whilst the interest rate in financial markets is determined by demand and supply for money, the natural interest rate is set by real factors. Money has nothing to do with the determination of interest rates in the real world of goods. According to Wicksell,
Now if money is loaned at this same rate of interest, it serves as nothing more than a cloak to cover a procedure which, from the purely formal point of view, could have been carried on equally well without it. The conditions of economic equilibrium are fulfilled in precisely the same manner.[4]
In the Wicksellian framework money only affects the price level. The effect of money on the price level is however not direct, it operates via the gap between the money market interest rate and the natural rate.
The mechanism works as follows – if the market rate falls below the natural rate, investment will exceed savings implying that aggregate demand will be greater than aggregate supply. Assuming that the excess demand is financed by the expansion in bank loans this leads to the creation of new money, which in turn pushes the general level of prices up.
Conversely, if the market rate rises above the natural rate, savings will exceed investment, aggregate supply will exceed aggregate demand, bank loans and the stock of money will contract, and prices will fall.[5] Hence whenever the market rate is in line with the natural rate the economy is in a state of equilibrium and there are neither upward nor downward pressures on the price level. It is deviations in the money market interest rate from the natural rate that sets in motion changes in the money supply which in turn disturb the general price level.
According to Wicksell,
If it were possible to ascertain and specify the current value of the natural rate, it would be seen that any deviation of the actual money rate from this natural rate is connected with rising or falling prices according as the deviation is downward or upward.[6]
Furthermore, Wicksell maintained that to establish whether monetary policy is tight or loose it is not enough to pay attention to the level of money market interest rates, but rather one needs to contrast money market interest rates with the natural rate.
If the market interest rate is above the natural rate then the policy stance is tight. Conversely, if the market rate is below the natural rate then the policy stance is loose.
How is one to implement this framework of thinking? The main problem here is that the natural interest rate can’t be observed. How can one tell whether the market interest rate is above or below the natural rate?
Wicksell suggested that policy makers pay close attention to changes in the price level. A rising price level would call for an upward adjustment in the money rate, while a falling price level would signal that the money interest rate must be lowered.[7]
Banks should adjust the money market interest rate in the same direction as movements in the price level.
Note that this procedure is followed today by all central banks. In response to increases in price indices above an accepted figure the Fed raises the federal funds rate target.
Conversely, when price indices are growing at a pace considered as too low the Fed lowers the target.
Despite the fact that the natural interest rate cannot be observed modern economists are of the view that it can be estimated by various indirect means. For instance, it is held, one can establish what it is simply by averaging the value of the real fed funds rate (fed funds rate minus price inflation) over a long period of time.
Some other economists hold that the natural rate fluctuates over time and reject the notion that the natural rate can be approximated by an average figure. In order to extract the unobservable moving natural interest rate economists now employ sophisticated mathematical methods for this.[8]
Are interest rates in financial markets and the real economy distinct phenomena?
Would it be possible in a world without money, such as suggested by Wicksell, to establish the rate of interest rate? In a world without money all that one would have are the rates of exchanges between various present and future real goods.
For instance, one present apple is exchanged for two potatoes in a one-year’s time. Or, one shirt is exchanged for three tomatoes in a one-year’s time. Again all that we have here are various ratios.
There is, however, no way to establish from these ratios what the rate of return is for one present apple in terms of future potatoes (It is not possible to calculate the percentage since potatoes and apples are not the same goods).
Only in the framework of the existence of money can the rate of return be established.
For instance, the time preference of a baker, which is established in accordance with his particular set-up, determines that he will be ready to lend ten dollars – which he has earned by selling ten loaves of bread – for a borrowers promise to repay eleven dollars in one year’s time.
Similarly the time preference of a shoemaker, which is formed in accordance with his particular set-up, determines that he will be a willing borrower. Once the deal is accomplished both parties to this deal have benefited. The baker will get eleven dollars in one-year’s time that he values much more than his present ten dollars. For the shoemaker the value of the present ten dollars exceeds the value of eleven dollars in one-year time.
As one can see here, both money and the real factor (time preferences) are involved in establishing the market interest rate, which is 10%. Note that the baker has exchanged ten loaves of bread for money first i.e. ten dollars. He then lends the ten-dollars for eleven dollars in one-year’s time. The interest rate that he secures for himself is 10%. In one-year’s time the baker can decide what goods to purchase with the obtained eleven dollars.
As far as the shoemaker is concerned he must generate enough shoes in order to enable him to secure at least eleven dollars to repay the loan to the baker.
Observe that without the existence of money – the medium of exchange – the baker isn’t able to establish how much of future goods he must be paid for his ten loaves of bread that would comply with the rate of return of 10%. One could argue that the shoemaker could repay the baker 11 loaves of bread in one year time. There is the issue here whether the bread in one year time could be regarded as identical to the bread at present. Without the existence of money even in this case it will be not that simple to establish the rate of return. Also, why would the baker agree to be paid in bread after all he has exchanged his saved bread to secure various other goods and services, such as shoes).
So if the rate of return is difficult to establish in the real economy apart from money it would be absurd to lend money without any connection to the real world – after all the role of money is to facilitate the exchange of real goods and services.
Consequently, there cannot be any separation between the real and financial market interest rates. There is only one interest rate, which is set by the interaction between individuals’ time preferences and the supply and demand for money.
Since the influences of the demand and supply for money and individuals’ time preferences regarding interest rate formation are intertwined, there are no ways or means to isolate these influences.
Hence, the commonly accepted practice of calculating the so-called real interest rate by subtracting percentage changes in the consumer price index from the market interest rate is erroneous.
So if the real interest rate cannot be ascertained it follows that the natural interest rate cannot be established either.
We can thus conclude that economists’ and central bankers’ attempts to establish the natural interest rate must therefore be regarded as an impossible mission.
Furthermore, according to the Wicksellian framework in order to maintain price and economic stability, once the gap between the financial market interest rate and the natural rate is closed the central bank must at all times ensure by means of a suitable monetary policy that the gap does not emerge. Maintaining a suitable policy would mean that the central bank would have to manipulate the supply of money, which in turn will make things unstable.
Conclusion
Our examination of the framework of thinking that the Fed’s decision makers use reveals that policies pursued by the US central bank will only promote more instability rather than achieving a balanced economy. The essence of the Fed’s thinking emanates from writings of Knut Wicksell, who suggested that the key to economic stability is targeting the financial market interest rate at the natural interest rate.
Our analysis has shown that it is not possible to isolate the so-called natural rate. Consequently, policies that are aimed at an unknown interest rate target run the risk of promoting more rather than less instability.
Also, even if one was to know what the natural rate was the act of reaching and maintaining this target by means of monetary policies will destabilize the economy. Any attempt therefore by means of policies to bring the market interest rate towards the natural rate and keep it there cannot be neutral with regard to the economy.
[1] Robert L. Hetzel, Henry Thornton: seminal monetary theorist and father of modern central bank. Economic Review, July/August 1987, Federal Reserve Bank of Richmond. Also, see Murray N. Rothbard, Classical Economics, An Austrian Perspective on the History of Economic Thought volume 2, Edward Elgar, p 177.
[2] Knut Wicksell “Interest and Prices” Reprints of Economic Classics, New York 1965. P 102. Originally written in January 1898.
[3] Karl Pribram, A History of Economic Reasoning, The John Hopkins University Press,1983, p322.
[4] Wicksell, p 104.
[5] Thomas M. Humphrey Interest rates, expectations, and the Wicksellian policy rule. Federal Reserve Bank of Richmond July 1975
[6] Wicksell, p 107.
[7] Knut Wicksell, “Interest and Prices” A study of the causes regulating the value of money. Reprints of economic classics, Augustus M. Kelley, Bookseller, New York 1965 p189.
[8] Thomas Laubach and John C Williams, “Measuring the Natural Rate of Interest”. Board of Governors of the Federal Reserve System, November 2001.
It seems almost axiomatic that given an adequate supply of money, the natural interest rate would hover very near to zero, and that today, anything off zero is likely a result on policy initiatives like IOR and ZIRP.
What happens with the focus on money ‘costs’ is a certain myopia about money ‘quantities’, the far more relevant economic outcome metric.
While Fisher may be concerned that the savings levels, etc. are inducing some negative effects on his preferred natural ‘cost’ of money, what he and other CBers should be focusing on are policy initiatives that can “increase” the money supply so as to advance the economy from today’s debt-saturated inertia.
The real problem we have is that the Fed has a mandate to use money and credit aggregates to achieve economic potential, but ZERO tools to increase the M&C aggregates beyond pushing on the policy string of targeting some money-cost metric.
It’s a fool’s errand.
We need a “monetary-fiscal framework” capable of advancing economic stability at a plateau level of non-inflationary full employment.
Following these inane FED observations and trying to craft an effective policy stance aimed at achieving that plateau leaves y’all joining in their errant errand.
Time for some “monetary financing of deficits”.
Time for some well-targeted Helicopter Money.
For the Money System Common .