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Natural and Neutral Rates of Interest Garrison 2 As theory and policy have developed, the terms “natural rate” and “neutral rate,” though seeming synonyms, provide a contrast between pre-Keynesian and post-Keynesian thinking. Although “natural” and “neutral” are sometimes used NATURAL AND NEUTRAL RATES OF INTEREST almost interchangeably, there is an important conceptual distinction in play: The natural rate of interest is a rate that emerges in the market as a result of borrowing IN THEORY AND POLICY FORMULATION and lending activity and governs the allocation of the economy’s resources over time. The neutral rate of interest is a rate that is imposed on the market by wisely ROGER W. GARRISON chosen monetary policy and is intended to govern the overall level of economic activity at each point in time. Exploring this distinction and its implications can go a long way towards understanding the current state of central-bank policymaking Interest has a title role in many pre-Keynesian writings as it does in Keynes’s own and the difficulties that the Federal Reserve creates for the market economy. General Theory of Employment, Interest, and Money (1936). Eugen Böhm Bawerk’s Capital and Interest (1884), Knut Wicksell’s Interest and Prices (1898) and Gustav Cassel’s The Nature and Necessity of Interest (1903) readily come to THE NATURAL RATE OF INTEREST mind. The essays in F. A. Hayek’s Prices, Interest and Investment (1939), which both predate and postdate Keynes’s book, focus on the critical role that interest So named by Swedish economist Knut Wicksell, the natural rate of interest is the rates play in coordinating production plans with consumption preferences. The rate that reflects the underlying real factors. In macroeconomic terms as applied General Theory represents a significant departure from classical (and Austrian) to a wholly private economy, it is the rate that governs the allocation of resources thinking but not because of the title-role status of interest. Rather, the departure between current consumption and investment for the future. By keeping saving and stems from the fact that, in Keynesian theory, the role played by a market- investment in balance, the natural rate guides the economy along a sustainable determined interest rate is a disruptive one. growth path. That is, governed by the natural rate, unconsumed current output (real In contemporary policy discussions, the interest rate occupies center stage if saving) is used for augmenting the economy’s productive capacity is ways that are only because the much-watched federal funds rate is the Federal Reserve’s sole consistent with people’s willingness to postpone consumption. surviving policy target. (A quarter-century ago, the Fed lost the ability to target the In the hands of the Austrian economists, the natural rate became the rate that money supply—or even to identify a distinctly relevant monetary magnitude.) By reflects the time preferences of market participants and allocates resources among its very nature an extra-market institution, the Federal Reserve is expected to exert the temporally defined stages of production. The output of one stage serves as input a countervailing force. It is to move against market forces that, presumably, would to the next in this logical and broadly descriptive representation of the economy’s otherwise be disruptive. In accordance with the Keynesian vision, market interest production process. The temporal dimension of the economy’s capital structure is rates fail to coordinate saving and investment decisions, leaving saving decisions a key macroeconomic variable in Austrian theory. Time preference is simply a dependent only on incomes and leaving investment decisions to be buffeted about summary term that refers to people’s preferred pattern of consumption over time. by Keynes’s “animal spirits.” Worse, high rates of interest can stem from fetishistic A reduction in time preferences means an increased future-orientation. People attitudes towards liquidity and a corresponding deficiency of spending. willingly save more in the present to increase the level of future consumption. The federal funds rate, which is the overnight rate on interbank loans, can be Their increased saving lowers the natural rate of interest and releases resources lowered or raised in an effort to control interest rates generally. The Federal from the final and late stages of production. Simultaneously, the lower natural rate, Reserve lowers the federal funds rate to stimulate spending and keep the economy which translates directly into reduced borrowing costs, makes early stage from sinking into recession; it raises the federal funds rate to retard spending and production activities more profitable. With the reallocation of resources from late keep prices and wages from spiraling upwards. Given the Keynesian vision and the to early stages of production, the preferred temporal pattern of consumption gets implied role for central bank policy, the so-called “art of central banking” is to pick translated into an accommodating adjustment of the economy’s structure of the “right” federal funds rate—the rate that wards off both unemployment and production. inflation. 3Natural and Neutral Rates of Interest Garrison 4 Movements in the natural rate are also critical to the economy’s performance an attractive backdrop for office holders seeking re-election. If the timing is right, when changes occur in the availability of resources or in technology. Suppose that the votes can be harvested before the seeming strength is revealed by the market a technological breakthrough makes a time-consuming production process much itself to be an actual weakness. more productive than before. Future consumption—even increased future The phenomenon of stimulating growth for political reasons has given rise to consumption—can now be secured with less of a sacrifice of current consumption. a whole literature on “political business cycles.” Whether the emphasis is on the People’s choices in the marketplace will determine how much of the technological intertemporal misallocation of resources (as the Austrian economists would have gain will be realized in terms of current consumption (less saving) and how much it) or on the alternating bouts of inflation and unemployment (as mainstream in terms of future consumption (in which the availability of a new technology macroeconomists would have it), political business cycle theory takes the more-than-offsets the effect of reduced saving). A rise in the natural rate during the underlying undistorted rate of interest to be consistent with macroeconomic health transition period is portrayed by the Austrian economists as an “interest-rate and the policy-infected interest rates (and money-growth rates) to be responsible brake,” a term we owe to Hayek (1933, pp. 94 and 179). The interest-rate brake for a macroeconomic malady in the form of boom and bust. Business cycles that moderates the rate at which the new technology is implemented and thereby allows are roughly aligned with the election cycle have been an integral part of the for increased current consumption even during the period of implementation. political landscape for the past half-century. In his Constitution of Liberty (1960), Inventories are drawn down in late stages of production and some resources are F. A. Hayek offered a blend of Austrian macroeconomics and what is now called reallocated toward less time consuming projects. Public Choice theory to account for these eco-political dynamics of boom and bust. In summary terms, the natural rate is seen as an equilibrating rate. It is the rate that tells the truth about the availability of resources for meeting present and future ACCOMMODATING GROWTH consumer demands, allowing production plans to be kept in line with the preferred In periods of technological advance, the Federal Reserve accommodates economic pattern of consumption. By implication, an unnatural, or artificial, rate of interest growth by lending freely at whatever rate of interest prevailed before the is a rate that reflects some extra-market influence and that creates a disconnect enhancements in technology occurred. Thus, interest rates are not actually lowered, between intertemporal consumption preferences and intertemporal production as in the case of stimulating growth. Rather, interest rates are simply not allowed plans. An artificially low rate of interest, which might prevail for some time if the to rise—as they would have in the absence of Federal Reserve accommodation. In Federal Reserve is targeting a low federal funds rate, translates into the business effect, the policy of accommodation overrides Hayek’s interest-rate brake. With world as longer planning horizons than is justified by people’s actual willingness given intertemporal preference, people would choose to take only a portion of the to save. The policy-induced mismatch between production and consumption gains associated with the technological advance in the form of increased future activities creates the illusion of prosperity but sets the stage for an eventual market consumption. They would choose to take at least some of those gains in the form correction, which takes the form of an economywide economic downturn. This is of increased current consumption. And given the enhanced technology, gains all the essence of the Austrian theory of the business cycle. The mismatch and around are possible. People can save less now and still enjoy more future resultant boom-bust sequence can occur as a result of two different but related
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