The Wicksellian Natural Rate of Interest
By Scott Sumner
The Richmond Fed has a new study of the natural rate of interest, by Thomas A. Lubik and Christian Matthes:
The natural rate of interest is one of the key concepts for understanding and interpreting macroeconomic relationships and the effects of monetary policy. Its modern usage dates back to the Swedish economist Knut Wicksell, who in 1898 defined it as the interest rate that is compatible with a stable price level. An increase in the interest rate above its natural rate contracts economic activity and leads to lower prices, while a decline relative to the natural rate has the opposite effect. In Wicksell’s view, equality of a market interest rate with its natural counterpart therefore guarantees price and economic stability.
A century later, Columbia University economist Michael Woodford brought renewed attention to the concept of the natural rate and connected it with modern macroeconomic thought. He demonstrated how a modern New Keynesian framework, with intertemporally optimizing and forward-looking consumers and firms that constantly react to economic shocks, gives rise to a natural rate of interest akin to Wicksell’s original concept. Woodford’s innovation was to show how the natural rate relates to economic fundamentals such as productivity shocks or changes in consumers’ preferences. Moreover, an inflation-targeting central bank can steer the economy toward the natural rate and price stability by conducting policy through the application of a Taylor rule, which links the policy rate to measures of economic activity and prices.
Naturally, monetary policymakers should have a deep interest in the level of the natural interest rate because it presents a guidepost as to whether policy is too tight or too loose, just as in Wicksell’s original view. The problem is that the natural rate is fundamentally unobservable.
Of course the Fed defines “price stability” as 2% inflation. The authors estimate how the natural rate has evolved over time, and then compare their estimates to the actual interest rate. After doing so they reach this bizarre conclusion:
The most notable finding, however, is that our estimate of the natural interest rate never turns negative. In addition, the natural rate has been above the measured real rate throughout the post-2009 recovery, which suggests that monetary policy has been too loose in the Wicksellian sense. This finding is qualitatively in line with Laubach and Williams, who also find a positive gap between the two rates, albeit a smaller one on account of their lower natural rate estimate.
I must be missing something really basic, as I would have expected exactly the opposite result. Since 2008, the inflation rate has usually been below the Fed’s 2% target, and if you add in employment (part of their dual mandate) they’ve consistently fallen short. This means that money has been too tight, i.e. the actual interest rate has clearly been above the Wicksellian equilibrium rate. But they find exactly the opposite result. Why? What am I missing?
PS. When I did my previous post on “Peoples QE” I had not noticed a similar one by Nick Rowe. Nick approaches the issue from a different angle, but reaches the same conclusion, indeed the only conclusion that seems to make any sense.