I want to say something briefly about the “neutral rate of interest,” which has recently become grist for financial television because of new Trump-appointed Fed Governor Stephen Miran’s speech a couple of days ago in which he opined that the neutral rate of interest is much lower than the Fed believes it is, and that therefore the Fed funds target should be more like 2%-2.25% right now instead of 4.25%.
Cue the usual media clowns screaming that this is evidence of how Trump appointees do not properly respect the academic work of their presumed betters.
If that was all this is, then I would wholeheartedly support Miran’s suggestion. Most of the academic work in monetary finance is just plain wrong, or worse it’s the wrong answer to the wrong question being asked. And that’s what we have here. Anyone who thinks that Miran is an economic-denialist should read the speech. It is mostly a well-reasoned argument about all the reasons that the neutral rate may be lower now than it has been in the past. And I applaud him when he comments “I don’t want to imply more precision than I think it possible in economics.” Indeed, if we were to be honest about the degree of precision with which we measure the economy in real time and the precision of the models (even assuming they’re parameterized properly, which is questionable), the Fed would almost never be able to decisively reject the null hypothesis that nothing important has changed and therefore no rate change is required!
I can’t say that I agree with Miran’s argument though. Not because it’s wrong, but because it’s completely irrelevant.
Sometimes I think that geeks with their models is just another form of ‘boys with their toys.’ And that is what is happening here. The “neutral rate of interest” is a concept that is cousin to NAIRU, the non-accelerating-inflation rate of unemployment. The neutral rate, often called ‘r-star’ r* (which is your clue that we’re arguing about models), is the theoretical interest rate that represents perfect balance, where the economy will neither tend to generate inflation, nor tend to generate unemployment. Like I said, it’s just like NAIRU which is a level of employment below which inflation accelerates. And they have something else in common: they are totally unobservable.
Now, lots of things are unobservable. For example, gravity is unobservable. Yet we have a very precise estimate of the gravitational constant[1] because we can make lots of really precise measurements and work it out. Economists would love for you to think that what they’re doing with r* is similar to calibrating our estimate of the gravitational constant. It’s not remotely similar, for (at least) two enormous reasons:
- Measuring the gravitational constant is only possible because we know (as much as anything can be known) what the formula is that we are calibrating. Fg=Gm1m2/r2. So all we have to do is measure the masses, measure the distance between the centers of gravity, and infer the force from something else.[2] Then we can back into G, the gravitational constant. Here’s the thing. The theory of how interest rates affect inflation and growth, despite being ensconced in literally-weighty economics tomes, is just a theory. Actually, several different theories. And, by the way, a theory with a terrible record of actually working. To calibrate r*, the hand-waving that is being done is ‘assume that interest rates affect the economy through a James and Bartles equilibrium…’ or something like that. It is an assumption that we shouldn’t accept. And if we don’t accept it, calibrating r* is just masturbation via mathematics.[3]
- With the gravitational constant, every subsequent measurement and experiment confirms the original measurement. Every use of the model and the constant in real life, say by sending a spacecraft slingshotting around Jupiter to visit Pluto, works with ridiculous precision. On the other hand, r* has approximately a zero percent success rate in forecasting actual outcomes with anything like useful precision, and every person who measures r* gets something totally different. And r* – if it is even a real thing, which I don’t think it is – evidently moves all the time, and no one knows how. Which is Miran’s point, but the upshot is really that monetary economists should stop pretending that they know what they’re doing.
In short, we are arguing about an unmeasurable mental construct that has no useful track record of success, and we are using that mental construct to argue about whether policy rates should be at 2% or 4%. Actually, even worse, Miran says that the market rate he looks at is the 5y, 5y forward real interest rate extracted from TIPS. The Fed has nothing to do with that rate. But if that’s what he is looking at why are we arguing about overnight rates?
I should say that if there is such a thing as a ‘neutral rate’ that neither stimulates nor dampens output and inflation, I would prefer to get there by first principles. It makes sense to me that the neutral long-term real rate should be something like the long-run real growth rate of the economy. And if that’s true, then Miran is probably at least directionally accurate because as our working population levels off and shrinks, the economy’s natural growth rate declines (unless productivity conveniently surges) since output is just the product of the number of hours worked times the output per hour. But I can’t imagine that the economy ‘cares’ (if I may anthropomorphize the economy) about a 1% change in the long-run real or nominal interest rate, at least on any time scale that a monetary policymaker can operate at.
The best answer here is that whether Miran is right or not, the Fed should just pick a level of interest rates…I’m good with 3-4% at the short end…and then change its meeting schedule to once every other year.
[1] Which may in fact not be constant, but that’s a topic for someone else’s blog.
[2] In the first experiment to measure gravity, which yours truly replicated for a science fair project in high school, Henry Cavendish in 1797 figured the force in this equation by measuring the torsion force exerted by the string from which his two-mass barbell was suspended, with one of those masses attracted to another nearby mass.
[3] Yeah, I said it.
