Brian Wesbury, chief economist at First Trust Advisors, offers in the WSJ an Austrian-sounding explanation of why (though I’m not sure of this “natural-rate = nominal GDP growth” stuff):
Despite record passenger traffic, airlines are bleeding cash and going bankrupt. Food riots have cropped up around the world, Canada is paying farmers to kill pigs because feed costs too much, and rice, it seems, is in very short supply.
While ethanol subsidies have created havoc, they don’t explain everything – like huge increases in precious metals prices, the sharp decline in the value of the dollar, or record-high fuel prices.
And the reason: “What’s missing in most analysis is the impact of inflationary monetary policy. Since 2001, and especially since September 2007 – when the Fed started cutting rates in response to credit market issues – excessively easy monetary policy has driven oil and other commodity prices through the roof.”
More:
Money is the ultimate commodity because all prices have only money in common. And it is the only thing that a central bank directly controls. Unfortunately, because of globalization and financial-market innovation, money itself has become hard to measure and useless as a forecasting tool. So analysts use interest rates.
The “natural rate of interest” is the theoretical interest rate at which monetary policy does not artificially boost the economy, nor hold it back. It is also the rate at which money is neutral on inflation. There have been many attempts at measuring this. Some economists look at real interest rates. Others use the Taylor Rule, which includes a target rate for inflation and real growth.
And while these methods are helpful, they rely on estimates. I devised a much simpler system back in 1993, based on actual economic data, that has proven extremely useful. It predicted the sharp increase in long-term interest rates in 1994; it also predicted the recession of 2001, the deflation of the early 2000s, and the inflation of recent years.
This model shows that a neutral federal funds rate should be roughly equal to nominal GDP growth. Nominal GDP growth (real growth plus inflation) measures total spending in the economy, or to put it another way, it reflects the average growth rate for all companies in the economy.
If interest rates are pushed well below nominal GDP growth, money is too easy and it encourages leverage. If interest rates are pulled above nominal GDP, money is too tight, and average companies cannot overcome borrowing costs.
Between 1960 and 1979, the federal funds rate averaged 5.6% and nominal GDP growth averaged 8.4%. With the funds rate 280 basis points below GDP growth, monetary policy was highly accommodative. The result: a falling dollar, rising commodity prices and fears that resources were being used up.
In 1980, then Fed Chairman Volcker lifted the fed funds rate significantly above GDP growth and held it there long enough to end inflation. This policy instigated a steep decline in oil prices, and drove a stake through the heart of stagflation.
Oil and inflation stayed low in the 1980s and ’90s, when the Fed held the fed funds rate 74 basis points above GDP growth on average. By 1999, with oil prices still low, the Economist magazine wrote that the world was “drowning in oil.”
Low inflation turned to deflation in 1999 and 2000, when the Fed mistakenly pushed the funds rate above nominal GDP growth again. This deflation spooked the Fed and led to a radical reduction in interest rates. Since then, the fed funds rate has been well below GDP growth – an average of 210 basis points – the most accommodative six years of monetary policy since the 1970s. No wonder inflation is on the rise and commodity prices are setting new records.
The Fed lifted the funds rate from 1% to 5.25% between 2004 and 2006, but monetary policy was never tight because the rate never went above nominal GDP. This suggests that housing market problems were not caused by tight money in 2006-07, but by excessive investment during the super-easy money of the years before.
Nonetheless, the Fed opened up the old playbook and cut rates aggressively when subprime loans blew up. This cemented higher inflation into place, crushed the dollar, pushed commodity prices up sharply, and created major problems in the energy, airline and agricultural marketplaces. And just like the 1970s, it is now popular to argue that the world is running out of resources again.
The answer to all of this is for the Fed to lift rates back to their natural rate, which is somewhere north of 5%. Tax-rate reductions and interest-rate hikes cured the world of its ills in the early 1980s. They can do so again.
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The formula for the “natural interest rate” is just a guess, that should/kind of/might be better than the Fed’s guesses, and if fully implemented SHOULD keep aggregate prices (Austrians forgive me) at a constant level.
But even if successful it will not in the least bit solve the issue he mentions. The issue is that NOBODY, not the Fed, not a super computer, not super-man, know the constantly changing preferences of millions of consumers. So no-one really knows a price of money or anything else for that matter.
Look at the plasma TV market. Prices are dropping in that area (I wonder if the Fed knows this as they refuse to let prices drop over 10%.) but rising in other places. That should be impossible. Except the businesses are locked in a struggle for profits with demanding consumers who do not have government or Fed on their side.
The natural rate is somewhere north of 5%? Check here for yields on treasury securities:
http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml
You’ll see 30 day rates at 1.17%, rising steadily to 4.49% for 30 year rates. This tells me that if the Fed is targeting the overnight rate at 2% (or anywhere north of 1.17%) the Fed is being too tight.
As for what rule the Fed should follow: The Fed only needs to make sure that every time it spends a dollar in bond markets, it gets a dollar’s worth of bonds in return. That way, the Fed’s assets will rise in step with its liabilities and the dollar will hold its value.
What is so confusing about the ‘natural rate?’
I guess it is confusing because there is a misunderstanding of what is the overall natural state of the economy.
Laissez-faire is the philosophical argument that the natural state is one with no economic intervention. But what is to keep someone from arguing a different viewpoint. Is it your word against mine?
I have news! There is a new economic theory that proves scientifically that any and all intervention into the economy is a corruption. It is not an argument, it is a scientific fact!
The best source of information about this new theory is MORE THAN LAISSEZ-FAIRE (2008) which can be found at http://divineec.ipower.com/page2.html .
Everyone knows the natural rate of interest should be 5.88389989434583%- give or take 0.0000000000002%.
Mike Sproul:
“As for what rule the Fed should follow: The Fed only needs to make sure that every time it spends a dollar in bond markets, it gets a dollar’s worth of bonds in return. That way, the Fed’s assets will rise in step with its liabilities and the dollar will hold its value.”
Does anybody else see that in fact the exact opposite will occur? That in fact the Fed would be creating money and (potentially) increasing/decreasing it’s value based on how much money was created?
“Does anybody else see that in fact the exact opposite will occur? ”
Almost everybody sees it but Sproul is a fellow that keeps pushing the real bill doctrine, which in reality is fantasy bill doctrine.
Value depends on supply and demand, not backing not anything.
Even in gold economy, where every single note is backed with gold, if the amount of gold increases more than demand for cash holdings the purchasing power of money decreases.
But in reality, unless someone discovers alchemy, the amount of gold can not increase substantially and gold holds its purchasing power thus keeps functioning as money. And that is the reason free market advocates are gold bugs, not that they like the yellow color.
RBD claims money is a magical thing that doesnt abide by the rules of supply and demand. As long as you increase the supply of the backing, you can increase the supply of money by the same amount without losing its purchasing power, it claims. And if that backing is just promisory notes, the supply of money will keep growing because it is free to write promises on paper.
Westbury’s definition of the natural interest rate is different from that of Austrians. He has adopted the terminology of neo-classical econ, which defines the natural rate of employment as that rate that causes neither price inflation nor deflation. I think Friedman came up with the idea. Westbuy has adapted the concept to the interest rate. His natural rate would allow the money supply to expand roughly the rate of real economic growth, similar to what a true gold standard would do.
Mike_Sproul: Your theory simply doesn’t match the data. The Fed, according to you, is being too tight, and yet instead of deflation, we see significant inflation. You are unable to explain this within your framework. Game over.
Btw, interest rates are low because the Fed is pushing them so low. Right now, risk-free rates are well below inflation. 1.2% ??? Give me a break! Time to load up on debt. (Got a car loan at 5.6%, looks like I’ll be paying it back in play money.)
yeah, fundamentalist’s right. volker hardly drove a stake through inflation’s heart (as opposed to cpi), though he did raise rates high enough to prick the commodities bubble of the seventies. money supply growth instead manifested itself in bonds and equities for the eighties and ninetines, with the brief interruption of the ’87 crash and early nineties recession.
i like to look at how many prestige swiss mechanical watch brands have sprouted up over the last twenty years (prices tags up to $500k and beyond).
the last time there was such a bloom of fine watches was the 1920′s. few manufactures have yet collapsed; in the 1930′s almost all the little marques went bankrupt or were bought by the few survivors.
bubbles still in the ultra-price car market, the fountain pen market, the straight-razor market, art market etc etc.
it’s going to be some garage sale.
“Canada is paying farmers to kill pigs because feed costs too much, and rice, it seems, is in very short supply.
i can’t wait for the bacon riots.
the fed funds rate and US treasury rates are completely different. the fed funds rate is the rate at which US banks lend qualified funds to EACH OTHER for one night. the treasury rates are the rates at which the US government, with the ability to print dollars, borrows from the public and other central banks. if you want to see if the fed funds rate is loose or tight, look at what banks are paying to borrow for periods other than overnight. LIBOR rates for 90 days are much higher than fed funds – the fed is loose.
fed funds rates and treasury rates are completely different. the fed funds rate is the rate that US banks lend qualified funds to EACH OTHER, overnight. the treasury rates are the rates at which the US govt, with control of the printing press, borrows from the public (and central banks). if you want to see if the fed has pushed the fed funds target rate too low (or high), look at the rates at which banks are borrowing other than fed funds. one month libor is about 70 basis points higher thans the fed funds target rate today. the fed is loose.
jls:
“one month libor is about 70 basis points higher thans the fed funds target rate today. the fed is loose.”
True; my mistake. The Fed funds rate is an interbank rate, and is best compared to other interbank rates like LIBOR/LIBID, not the rate on Treasuries.
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