Download A lower neutral rate: causes and consequences

A closer look
A lower neutral rate:
causes and consequences
August 2016
Joshua N. Feinman
Chief Global Economist
Deutsche Asset Management
Phone: 212-454-7964
Email: [email protected]
A closer look 1
A closer look
A lower neutral rate: causes and consequences
Are super-low interest rates here to stay? There is
a growing consensus that they are. Interest rates
have been running at extraordinarily low levels
—negative in real terms in virtually all advanced
economies, and even in nominal terms in quite a
few. And it’s not as if these rock-bottom interest
rates have been fomenting inflationary booms. On
the contrary, economic growth has been sluggish,
well below what might have been expected to
ensue from such low interest rates, while resources
remain underutilized in many countries and almost
all continue to struggle with below-target inflation.
It’s little wonder, then, that people have pared
their estimates of the “neutral” rate of interest—
the real, short-term interest rate consistent with
the economy operating at its potential and with
inflation being stable. What’s more, it’s looking
increasingly as if this lower neutral rate isn’t just a
temporary artifact of the financial crisis and Great
Recession, but rather a more enduring feature of
the landscape. There were hints that the neutral rate
may have begun to slip even before the crisis, but
what has really solidified the case is that economic
recoveries around much of the world have remained
disappointing and incomplete for so long, even
as the headwinds from the crisis have faded and
interest rates have plumbed new depths. And
there are sound reasons why the neutral rate may
have fallen. Slower potential economic growth,
the result of weaker demographics and more
sluggish productivity trends that have restrained the
demand for and the return on investment capital,
coupled with an increased proclivity to save (partly
demographic, partly perhaps reflecting lasting scars
from the crisis), not only in advanced economies
but in many emerging ones too, are examples of the
kinds of forces that may be depressing the neutral
rate. While some of these forces may yet diminish,
others appear increasingly to have staying power.
Financial markets certainly seem to think so.
Fixed-income markets appear to be pricing in
the persistence of very low short-terms rates for
a long time, not only in the U.S., but especially
in Europe and Japan, and yet don’t anticipate
these low rates to be inflationary, suggesting that
market participants have permanently lowered their
estimates of the neutral rate. So too have many
forecasters and policymakers, albeit perhaps not
quite as far; for example, the Blue Chip consensus
forecast of the level of short-term rates likely to
prevail over the long run in the U.S. has declined
more than 150 basis points since the financial crisis,
after having already begun to edge lower in prior
years, while the FOMC has trimmed its median
estimate of the federal funds rate apt to prevail in
the long run by 1-1/4% over the past couple of years.
Model-based estimates of the neutral rate have
come down too. These models aim to tease out
estimates of the (unobservable) neutral rate by
studying the relationships between actual interest
rates, output, inflation, and estimates of potential
output. Doing so is tricky, of course, and subject to
considerable uncertainty. Yet most models suggest
that the neutral rate has fallen sharply in the U.S.,
especially since the financial crisis and Great
Recession.1 The precipitous contraction in output
A closer look 2
in 2008 and 2009, coinciding as it did with a steep
decline in real interest rates was a powerful signal
that the neutral rate had declined, while the failure
of inflation to fall even further was an indication
that potential output had been damaged (i.e., that
the collapse in output created less disinflationary
slack than it would have had potential remained
unscathed). During the recovery, growth has fallen
well shy of what historical norms would have
suggested given how low real interest rates have
been, and the output gap has also closed more
slowly than might have been expected given such
low real rates (though more quickly than if potential
output hadn’t been damaged), reinforcing the
conclusion that the neutral rate remains depressed.
years of much-improved economic performance—
stronger growth and a convincing return to (or even
beyond) full employment and targeted inflation—all
coming against the backdrop of higher real interest
rates, for estimates of the neutral rate to move back
near historical norms. Though this can’t be ruled
out, it seems unlikely given recent experience and
the solid theoretical rationales for a lower neutral
rate. And even if it did happen, we wouldn’t have
convincing evidence of it for quite a while. So for the
foreseeable future, the working hypothesis will likely
remain that the neutral rate is much lower than it
used to be. And that has profound consequences.
Implications
And it’s not just a U.S. story; the neutral rate is
estimated to have declined in most other advanced
economies too (e.g., Euro-area, UK, Canada).2
Again, there are wide bands of confidence around
specific estimates here; different assumptions
and modeling techniques lead to different point
estimates of the neutral rate and alternative
trajectories of just how far it fell in the immediate
aftermath of the crisis, and how much (if at all)
it has recovered since. Some of the differences
hinge on how much weight specific models put on
movements in inflation to inform their judgments
about potential output and, by implication, the
neutral rate. Some models, for example, view
the failure of inflation to fall even further in the
aftermath of the Great Recession less as a sign
of damaged potential output and more the result
of stable inflation expectations and downward
nominal wage rigidity. As a result, they estimate an
even wider opening of the output gap and steeper
fall in the neutral rate at that time. But they also
judge that the neutral rate has bounced back from
these lows because in these models the substantial
improvement in the labor market is taken as a sign
that slack has been much reduced (the persistence
of low inflation is deemed more the result of
inertia in the inflation process). Still, even in these
frameworks, the neutral rate is estimated to remain
well below norms prevailing in prior cycles. And
that is perhaps the key takeaway. Even allowing for
alternative modeling strategies and wide confidence
intervals around specific point estimates, the nearly
unanimous conclusion is that the neutral rate
remains far below where it was in the past.
Of course, that conclusion could change. But not
likely overnight. It would probably take several
A lower neutral rate obviously matters for monetary
policy, but it also impacts government debt
dynamics and valuations of things like equities,
houses, and pension liabilities—anything whose
value hinges on future cash flows that have to be
discounted to the present.
Monetary policy
The neutral rate isn’t something that monetary
policymakers can influence, or pinpoint precisely,
but it is something they must take into account.
In that sense, it is like the economy’s potential
growth rate, or its maximum, sustainable levels
of output and employment—a time-varying, hardto-estimate structural parameter largely beyond
the reach of monetary policy but one that factors
importantly into how that policy must be calibrated.
In a typical Taylor-type rule, for example, the level
of short-term interest rates set by the central bank
depends not only on the level of inflation relative
to target and on assessments of the gap between
actual and potential output, but also on estimates
of the neutral rate. If those estimates decline, all
else equal, so too must the rate set by the central
bank, lest monetary policy implicitly tighten. Put
differently, if the neutral rate has declined, actual
rates may not be as accommodative as history
would suggest—or, equivalently, policymakers must
set rates lower than in the past to provide the same
degree of accommodation.
Few doubted this was true in the aftermath of
the financial crisis. But it was generally expected
that the crisis headwinds would fade with time,
A closer look 3
lifting the neutral rate back up, at least in part, and
that as it rebounded the U.S. Federal Reserve (the
Fed) would need to raise rates in order to avoid
overstaying an accommodative policy. As the years
have passed, though, and real rates have persisted
at negative levels yet the economy has not grown
nearly as rapidly as might have been expected,
nor slack absorbed quite as quickly nor inflation
rebounded much, the view has grown that the
decline in the neutral rate may be more enduring,
a consequence of things like slower potential
growth, increased saving propensities, and reduced
investment inclinations, not only in the U.S., but
globally. That means interest rates have less distance
to travel to be restored to a neutral setting. This is
one reason policymakers have been slow to raise
rates; they’re not only wary of heightened global
stresses, lingering slack, below-target inflation, and
asymmetric risks near the zero bound, and hold
out hope that supporting demand can help repair
at least some of the damage to potential output
(by enticing more people back into the labor force
and encouraging firms to invest more in productivity
enhancements), they also increasingly judge that the
neutral rate will remain lower for longer.
That doesn’t mean the Fed will never raise rates
again. Virtually all estimates suggest the current
policy setting is still accommodative (especially
given the Fed’s enlarged balance sheet, which is
holding down longer-term rates), and may become
more so over time if the neutral rate edges back
up, if only somewhat. Moreover, part of the reason
the neutral rate is lower is that potential growth is
lower—and there is only so much, if anything, that
monetary policy can do about that. That means
policymakers need to recalibrate on several fronts: a
given real interest rate is less accommodative than
in the past, but a given rate of economic growth
is more likely to exceed the economy’s diminished
potential and thus reduce slack, suggesting a greater
need to remove accommodation. On balance, we
still see the Fed as inclined to raise rates (provided
the outlook continues to suggest progress toward
full employment and price stability), though we
continue to expect those increases to come slowly,
and leave rates low by historical standards, in part
because of a lower neutral rate.
A higher inflation target?
lower neutral rate: it argues not only for a shallower
glide path of rate increases to achieve the Fed’s
dual mandate, it also makes a case for bumping
up the inflation target that is part of that mandate.
Otherwise, encounters with the zero bound on
nominal interest rates and threats of deflation may
recur more frequently than they did in the past,
when the neutral real rate was higher, and the Fed
will have less room to cut real rates in response
to adverse shocks. Keep in mind that the Fed (and
most other central banks) chose 2% as an inflation
target because that rate was viewed as low enough
to render inflation a small consideration in people’s
planning but not so low as to erode the buffer
against shocks that could tip the economy into
damaging deflation or cause it to bump up against
the zero bound on nominal interest rates. But the
size of that buffer was selected in part based on
estimates of the neutral real rate. If those estimates
have declined, the inflation target would need to
be raised commensurately to restore the same
buffer in terms of nominal interest rates and give
policymakers the same scope to cut real rates to
combat cyclical weakness in the economy.
No change in inflation target is imminent, though;
policymakers are having enough trouble getting
inflation back up to 2%—raising the bar would
make their task even more difficult. They might
also fear that bumping up the inflation target
would jeopardize their vital credibility, risking
an unmooring of inflation expectations. And it’s
not as if central bankers are completely out of
ammunition when short-term rates hit zero; even if
they are reluctant to drive rates negative, they can
use other tools—including forward guidance and
asset purchases—to provide stimulus, and while
the efficacy of these measures may be harder to
gauge than conventional rate cuts, they’ve generally
been found to help. Policymakers would need to
be firmly convinced that the neutral rate was a lot
lower and was going to stay there before they’d
even think about raising the inflation target. That
seems a bridge too far, at least for now. But a higher
inflation target might be contemplated sometime in
the future—perhaps if the economy enters the next
recession with rates not far from zero, leaving the
Fed with little conventional policy ammunition—
and in the meantime, provides another reason why
policymakers may be a little slower to hike rates
until inflation gets back to 2%, if not even a
bit beyond.
There is another, more controversial implication of a
A closer look 4
A rise in inflation might also provide a clearer
signal that slack has been exhausted and that the
neutral rate may be starting to move back up. It’s
not hard to imagine why policymakers would be
looking for some confirmation on the inflation front.
The economy’s unusual performance in recent
years—abnormally low interest rates, slower-thananticipated growth yet greater-than-expected
declines in labor market slack juxtaposed against
persistently below-target inflation—has left many
(both inside and outside the Fed) scratching their
heads, less certain of many things, including the
neutral rate, potential growth, and slack. That
would argue for putting less weight on these hardto-estimate parameters and more emphasis on
inflation itself—both to inform judgments about the
neutral rate and slack, and to guide policymaking.
This hardly means the Fed will wait for inflation
to move convincingly to target (if not beyond)
before raising rates at all; that kind of delay risks
a potentially destabilizing overshoot, especially
given the lags between policy, the real economy,
and inflation. But it does offer yet another reason
why the Fed will likely tread carefully in lifting rates,
unless and until inflation shows convincing signs
of picking up.
Fiscal policy and debt dynamics
A lower neutral rate can also impact government
debt dynamics and the choices confronting fiscal
policymakers. A permanently lower neutral rate,
all else equal, would unambiguously improve
the government’s fiscal position by lowering its
cost of borrowing. But all else may not be equal.
If the decline in the neutral rate is the result of
a matching decline in the economy’s potential
growth rate, there is little if any net benefit to
government finances. Only to the extent that the fall
in the neutral rate exceeds the decline in potential
growth does the government gain fiscal flexibility.
Fortunately, that seems to be the case; most
estimates suggest that the neutral rate has fallen
somewhat more than potential growth, as changes
in global saving and investment inclinations have
apparently had a greater impact on interest rates
than growth. If so, governments will be able to run
slightly larger primary budget deficits (i.e. deficits
excluding interest payments) without raising the
debt-to-GDP ratio, and even in countries where
potential growth remains below the government’s
borrowing rate, that gap would narrow, implying
that slightly smaller primary surpluses would be
needed to stabilize the debt ratio.3 This added room
for fiscal maneuver opens a window for things like
tax cuts and infrastructure spending that could
help not only support aggregate demand and
close remaining output gaps, but perhaps even lift
potential output and the neutral rate a bit (in part by
offsetting the private sector’s disinclination to invest
and borrow). But the benefits here shouldn’t be
oversold; a lower neutral rate is hardly a blank check
for governments, and fiscal stimulus is no panacea
for what’s ailing potential growth. Help on this front,
if there is any at all, would likely entail structural
reforms too (e.g., tax and regulatory reform, efforts
to boost competition, reduce barriers to entry for
new firms and disincentives for people to join the
labor force, allow more high-skilled immigration,
open up more international trade, etc.). Still, fiscal
stimulus might help, and the decline in the neutral
rate makes such stimulus more viable.
Valuations
The value of many assets and liabilities, particularly
those that depend on expected future cash flows
that have to be discounted to the present, may be
affected by a lower neutral rate. Consider equities,
for example. Their value hinges on expected
future free corporate cash flows, discounted at
an appropriate interest rate—typically, a risk-free
rate plus a premium that reflects the inherent
risk characteristics of equities (generally, their
covariance with other things in the investor’s
portfolio or, more fundamentally, with the investor’s
consumption), and the willingness of investors to
bear that risk. If the risk-free rate declines, all else
equal, equities become more valuable; that is, for
given risk characteristics and appetites, investors
will be willing to pay more for the same expected
future stream of free cash flows if the risk-free rate
is lower. But once again, all else might not be equal.
If real interest rates are lower because potential
growth is lower, then free corporate cash flows will
presumably not be expected to grow as rapidly. And
if the lower neutral rate also reflects an increased
proclivity to save borne of reduced risk appetite,
then the benefit to equity valuations is further
eroded. It is only to the extent that the decline in the
neutral rate is greater than any decline in expected
future profit growth and in risk appetite that equity
valuations get a boost. And that boost would only
be temporary anyway; once equity prices have
A closer look 5
adjusted upward, from that point forward equity
returns will actually be lower than before, reflecting
the lower risk-free rate and slower expected growth
of cash flows. It’s a similar story with other assets,
like houses. A decline in real interest rates will lift
home prices only to the extent that it exceeds any
corresponding decline in expected future rents (due
to slower potential growth) and diminishment of risk
appetite. It’s the same for liabilities like pensions,
only in the opposite direction. A lower neutral
rate raises the discounted value of future pension
liabilities, unless it is offset by slower expected
growth in those liabilities (due, say, to slower wage
growth in a world of slower potential growth).
For examples of some of the research underlying these empirical estimates of the neutral rate, see:
Christiano, Lawrence J., Roberto Motto, and Massimo Rostagno (2014). “Risk Shocks,” American Economic Review (January).
Del Negro, Marco, Stefano Eusepi, Marc Giannoni, Argia Sbordone, Andrea Tambalotti, Matthew Cocci, Raiden Hasegawa, and
M. Henry Linder (2013). “The FRBNY DSGE Model,” Federal Reserve Bank of New York Staff Reports 647 (October).
Guerrieri, Luca, and Matteo Iacoviello (2013). “Collateral Constraints and Macroeconomic Asymmetries,” International Finance
Discussion Papers 1082r, Board of Governors of the Federal Reserve System (June; revised July 2014).
Kiley, Michael T. (2013). “Output Gaps,” Journal of Macroeconomics, vol. 37 (September).
Laubach, Thomas, and John C. Williams (2015). “Measuring the Natural Rate of Interest Redux,” Hutchins Center Working Papers 15,
Brookings Institution (November).
2
Holston, Kathryn, Thomas Laubach, and John C. Williams (2016), “Measuring the Natural Rate of Interest: International Trends and
Determinants,” Federal Reserve Bank of San Francisco Working Paper (June).
3
For details on government debt dynamics, see, for example:
Contessi, Silvio (2012). “An Application of Conventional Sovereign Debt Sustainability Analysis to the Current Debt Crises,”
Federal Reserve Bank of St. Louis Review.
1
A closer look 6
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All opinions and forecasts are as of the date of this document, subject to change at any time and may not
come to pass.
Definitions
The federal funds rate is the interest rate, set by the U.S. Federal Reserve, at which banks lend money to
each other, usually on an overnight basis.
The Federal Open Market Committee (FOMC) is a committee that oversees the open-market operations of
the U.S. Federal Reserve.
The Great Recession refers to the prolonged economic downturn in much of the world after the financial
crisis of 2007-08.
Inflation is the rate at which the general level of prices for goods and services is rising and, subsequently,
purchasing power is falling.
In economics, a Taylor rule refers to a monetary policy rule which stipulates how much a central bank should
change the nominal interest rate in response to changes to inflation, output or other economic conditions.
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