This is an excerpt of the September 2013 Longbrake Letter. To read the letter in its entirety, click here.
It is conventional wisdom that when the economy is at full employment and booming the Federal Reserve should raise the federal funds rate. When unemployment is high and the output gap is large the Federal Reserve should lower the federal funds rate. The rationale is that by changing the cost of money, the Federal Reserve can either stimulate or discourage investment and spending and in so doing boost or dampen economic activity. The objective of monetary policy is to promote full employment at low and stable rates of inflation and dampen cyclical fluctuations.
While the federal funds rate is one of many market rates of interest, it is the one traditionally that the Federal Reserve manipulates in its attempt to modulate economic activity over the business cycle. Because the level of long-term interest rates depends upon the current short-term interest rate, the federal funds rate, and future expected values of the federal funds rate, the Federal Reserve can influence interest rates across the maturity spectrum by setting the current value of the federal funds rate and signaling its future intentions.
Policy risk arises if the Federal Reserve’s implementation of monetary policy results in setting the market rate of interest at a level that is above or below the natural rate of interest. But because the natural rate is unobservable it is difficult to know when the market rate of interest differs from the natural rate. To understand why divergence between the two rates leads to policy risk, it is important to know what the natural rate of interest is and why, when it differs from the market rate of interest, policy risk is triggered and can build to troublesome levels if the divergence between the market rate and the natural rate is large and persists for a long period of time.
Investment, Saving and the Natural Rate of Interest. The natural rate of interest is that rate of interest at which intended investment and intended saving balance. This is the same concept as the intersection of a demand and supply curve for a product, such as sugar, which determines its market price.
After the fact, or ex post in economic jargon, investment and saving are always equal. But realized investment and saving may not be what investors and savers intended, which is an ex ante concept in economic jargon. Because intended investment and intended saving are not directly observable it follows that the natural rate of interest cannot be known with certainty.
According to theory, if the expected return on an investment in a productive asset is greater than the natural rate of interest, that investment should be undertaken. A saver has a choice between current and future consumption. A low interest rate encourages current consumption; a high interest rate encourages saving and a deferral of consumption. The equilibrium natural rate of interest occurs at the rate that induces enough savings – supply of funds – to fund investments – demand for funds – whose expected returns exceed the equilibrium rate of interest.
Since the natural rate of interest is not observable, actual decisions are based upon the market rate of interest. But, if the market rate of interest is different from the natural rate, some decisions will be “incorrect”. This initiates policy risk and its magnitude will depend on the size, direction, and persistence of the divergence between the natural and market rates of interest. Because the Federal Reserve controls the market rate of interest, it can become the source of policy risk by setting a market rate of interest that is inconsistent with the natural rate of interest.
What Happens When the Market Rate and Natural Rate of Interest Diverge? When the market rate of interest is set below the natural rate of interest, money is said to be cheap and investments will be funded whose expected rates of return are below the natural rate of interest but above the market rate of interest. While this is intuitively obvious, the macroeconomic implications are less obvious.
Economic growth depends upon investment in new productive assets. When money is too cheap investment will occur not only in productive assets but also in less productive assets such as building roads and bridges to nowhere. But when money is cheap it will also flow into existing investments with the result that the prices of existing assets are bid up. This can happen directly into real assets, such as real estate, or indirectly into financial assets, such as stocks and bonds. Prices of existing assets, then, inflate above “fair” value.
This is the phenomenon that Hyman Minsky described in his financial instability hypothesis. A market rate set below the natural rate leads to speculation and in the extreme to Ponzi finance and unsustainable bubbles. As a reminder, Minsky’s financial instability hypothesis posits three levels. The first level is “normal finance” where investments are made based on expected cash flows from the investment sufficient to cover payment of principal and interest on the debt that finances the investment. This is the level that is consistent with a market rate of interest that equals the natural rate of interest. The second stage is “speculative finance” where investment cash flows are sufficient to cover principal repayment but insufficient to cover interest payments, thus requiring perpetual refinancing. The third stage – the bubble stage – is “Ponzi finance” where cash flows from investments are insufficient to cover both principal and interest. Asset prices are bid up to unsustainable levels which eventually lead to a bust.
Cheap money and debt leverage are a deadly combination as we have seen from experience. They combine to facilitate speculative and Ponzi finance. Profits accrue to speculators rather than to investors in new productive assets with the result that funds are diverted into existing assets and away from new productive assets. A quick buck can be made through speculation while returns on productive investments are uncertain and are only realized over a long period of time. This misallocation of profits is contributing to a worsening of income inequality. Moreover, it should not come as a surprise that private investment growth, as measured in the national income accounts, began to decline in 2006 well before Lehman collapsed in September 2008. The 2006 to 2008 period was clearly one in which Minsky’s “Ponzi finance” held full sway.
Thus, a market rate of interest that is below the natural rate of interest will lead over a period of time to the misallocation of funds into speculative activity involving existing assets. Investments in new productive assets will be neglected with the consequence that growth in the stock of capital will slow or even decline. Growth in the stock of capital is necessary to raise productivity. So, it follows, that slower growth in the capital stock or even shrinkage in the capital stock will depress productivity. And, as discussed above, lower productivity results in decreasing the structural potential real rate of GDP growth.
When bubbles burst, asset values fall back to levels consistent with the natural rate of interest. But the nominal value of debt remains unchanged. This forces bankruptcies. The provision of copious amounts of liquidity by the Federal Reserve at cheap market rates can forestall contagion and a downward and lethal debt-deflation spiral. But, this kind of market stabilization intervention can also slow the process of right-sizing the stock of nominal debt relative to the stock of assets fairly valued at the natural rate of interest. The overhang of too much debt serves as a barrier to new investment. This phenomenon is probably an explanation, at least in part, for the on-going depressed level of new business formation. In any event, debt overhang is correlated with depressed or negative growth in the stock of capital. And, slower growth in the capital stock or shrinkage depresses productivity and the structural rate of real GDP growth.
Monetary Policy Can Contribute to Reducing the Structural Potential Real Rate of GDP Growth. Monetary policy’s role is to drive the market rate of interest down when the economy is underperforming. The objective is to stimulate investment and consumer spending. But, if the market rate is set too low and is maintained at too low a level for too long, it will prompt misallocation of investment into price speculation involving existing assets. This policy risk is not trivial and is inherent in the Federal Reserve’s recent monetary policy. The question worth pondering is whether monetary policy has migrated from serving as a cyclical stabilizing influence to contributing to a permanently lower level of potential real GDP growth.
Recovery in real economic activity and employment following the Great Recession has been disappointingly lethargic given the Federal Reserve’s exceptionally easy monetary policy. And, recovery has been accompanied by some troublesome trends. For example, income equality is worsening according to an updated study by Emmanuel Saez and Thomas Piketty. At the same time corporate profit margins have escalated to all-time highs. New job creation is anemic and appears to be related to a low level of new business formation and barriers to investment.
 Annie Lowrey. “The Rich Get Richer Through the Recovery,” New York Times, September 10, 2013. The share of income of the top 1% was 22.5% in 2012 compared to 19.7% in 2011 and matched the highs that preceded the Great Depression and Great Recession. The top 1% has “captured” about 95% of the aggregate increase in income since the end of the Great Recession.