Working Paper #15 November 2, 2015 MEASURING THE NATURAL RATE OF INTEREST REDUX* Thomas Laubach Board of Governors of the Federal Reserve System John C. Williams Federal Reserve Bank of San Francisco SUMMARY Persistently low real interest rates have prompted the question whether low interest rates are here to stay. This essay assesses the empirical evidence regarding the natural rate of interest in the United States using the Laubach-Williams model. Since the start of the Great Recession, the estimated natural rate of interest fell sharply and shows no sign of recovering. These results are robust to alternative model specifications. If the natural rate remains low, future episodes of hitting the zero lower bound are likely to be frequent and long-lasting. In addition, uncertainty about the natural rate argues for policy approaches that are more robust to mismeasurement of natural rates. *The views expressed here are solely those of the authors and do not necessarily reflect those of others in the Federal Reserve System. Contact information: Laubach: Board of Governors of the Federal Reserve System, Washington, DC 20551; email: [email protected]; Williams: Federal Reserve Bank of San Francisco, 101 Market St., San Francisco, CA 94105; email: [email protected]; phone: 415-974-2121. Hutchins Center Working Paper #15 INTRODUCTION Year after year of extraordinarily low interest rates in the United States and elsewhere have prompted the question whether low interest rates are a permanent feature of the future economic landscape. The answer to this question has important implications for the economy, asset prices, and monetary policy. A great deal has been written on why the equilibrium or “natural” real interest rate may be low in the future, with the theory of secular stagnation one prominent example (Summers 2014). In this essay, we assess the empirical evidence regarding the historical behavior of the natural rate of interest in the United States, with a particular focus on the period since the outbreak of the global financial crisis. We then turn to implications for monetary policy. Our analysis centers on the model that we developed to measure highly persistent movements in the natural rate of interest (Laubach and Williams 2003). According to this model, since the start of the Great Recession the natural rate of interest has fallen to, and remained at, historically very low levels near zero. This is in part explained by a significant decline in the trend growth rate of the economy, but other factors that are harder to pin down are also at play. We find no evidence that the natural rate has moved back up even with the economy close to fully recovered from the Great Recession. These results are robust to alternative approaches to estimating the natural rate of interest and the output gap. In the final part of this essay we consider two key policy implications of a variable natural rate of interest in general, and of the decline and subsequent low level of the natural rate since the Great Recession in particular. First, uncertainty about the natural rate of interest argues in favor of policy approaches that deemphasize the role of the natural rate in policy decisions and therefore make these decisions more robust to potentially mismeasured natural rates. Second, if the natural rate were to remain as low as it has been since 2008, episodes in which short-term interest rates would be constrained from below would become more frequent and long-lasting, and unconventional policy tools may continue to play an important role in the future. DEFINING THE NATURAL RATE OF INTEREST Knut Wicksell (1898) famously characterized the natural rate of interest: “There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tends neither to raise nor to lower them.” We operationalize this notion by defining the natural rate as the real short-term interest rate consistent with the economy operating at its full potential once transitory shocks to aggregate supply or demand have abated. Implicit in this definition is the absence of upward or downward pressures on the rate of price inflation relative to its trend. Our definition takes a “longer-run” perspective, in that it refers to the level of real interest rates expected to prevail, say, five to 10 years in the future, after the economy has emerged from any cyclical fluctuations and is expanding at its trend rate. In contrast, other research has focused on short-term fluctuations in the natural rate of interest, assuming the longer-run value is constant (Neiss and Nelson 2001, Woodford 2003, Andres et al., 2009, Barsky et al., 2014, Curdia et al., 2015). These studies define the natural rate to be the real interest rate that would 1 Hutchins Center Working Paper #15 prevail if all prices were flexible. However, we do not view this as a competing or contradictory approach to defining the natural rate; rather, the short-term perspective is complementary to our longer- run approach. Figure 1 portrays a highly stylized model of the determination of the natural rate. The downward-sloping line, labelled the IS curve, shows the negative relationship between aggregate spending and the real interest rate. The vertical line indicates the level of potential GDP, which is assumed to be unrelated to the real interest rate for this diagram. In principle, potential GDP may also a function of the real rate, but this modification does not affect the basic point of the analysis. At the intersection of the IS curve and the potential GDP line, real GDP equals potential, and the real interest rate equals the natural rate of interest. Figure 1: Determination of the natural rate of interest Real interest rate Potential GDP Natural rate of interest IS Curve GDP The natural rate of interest may change over time owing to highly persistent structural shifts in aggregate supply and demand. For example, Laubach (2009) finds that increases in long-run projections of federal government budget deficits are related to increases in expected long-term real interest rates. In Figure 1, an increase in long-run projected budget deficits moves the IS curve to the right, implying a higher natural rate. As discussed by Bomfim (1997), Laubach and Williams (2003), Congressional Budget Office (2014), International Monetary Fund (2014), Hamilton et al. (2015), and Kiley (2015), there are myriad influences on the natural rate, including, but not limited to, productivity growth, demographics, and the evolution of the global economy. Univariate time series estimates Although it is relatively straightforward to define the natural rate of interest, it is more challenging to pin it down quantitatively. If the natural rate were close to constant over time and there were no trend in the inflation rate, a reasonable estimate would be the sample mean of actual real interest rates. For example, the ex post real fed funds rate--defined as the nominal effective federal funds rate less the percent change in the personal consumption expenditures price index over the prior year-- has averaged about 2% over 2 Hutchins Center Working Paper #15 the past 50 years. If history were a good guide, then one would expect real interest rates to return to 2% in the future. However, factors affecting supply and demand evolve over time, shifting the natural rate around. If these movements are sufficiently large and persistent, the long-term average is a poor predictor of the natural rate of interest. A standard way to allow for persistent changes is to compute multi-year averages of past values. Figure 2 illustrates this approach, showing the ten-year moving average of ex post real short-term interest rates in the United States and the corresponding figure for the median real short-term interest rate across 17 advanced economies. The data are from an updated version of the Schularick and Taylor (2012) data set. One observation stands out from this figure: there are sizable swings in average real interest rates that persist for decades. Figure 2: 10-year averages of ex post real short-term interest rates Percent 10 United States 6 Median across counries 2 -2 -6 Other more sophisticated statistical approaches use time-series filtering techniques that try to separate longer-term trends from short-term variations. Figure 3 shows three such sets of estimates of the medium- or longer-term trends using the Hodrick-Prescott filter, the bandpass filter, and an unobserved components stochastic volatility model (Stock and Watson 2007). The five-year moving average of real interest rates is also shown for comparison. 3 Hutchins Center Working Paper #15 Figure 3: Univariate measures of trend real interest rates Percent 12 Stock-Watson UCSV model Bandpass filter Hodrick-Prescott filter 8 Real federal funds rate, 5 year average 4 0 -4 1961 1969 1977 1985 1993 2001 2009 Note: Gray bands denote NBER recessions. Although such univariate time series methods could in principle work well at estimating the natural rate of interest when inflation and economic activity are relatively stable, they are likely to be unreliable during periods when this is not the case, indicating that real interest rates have deviated from the natural rate for some time. For example, during the late 1960s and much of the 1970s, inflation trended steeply upward in the United States, which suggests that the real funds rate was below the natural rate on average. Similarly, real interest rates were very high during the period of the Volcker disinflation of the early 1980s, when inflation fell sharply. The univariate time series approaches cannot control for these developments and ascribe this pattern of low, and then high, real interest rates to the trend in real interest rates, as seen in the figure.