Sunday, October 11, 2020

The challenge of finding r-star

IMF economist Peter Williams joined Joe and Tracy on the Odd Lots podcast to discuss the neutral rate of interest, R*. This is the theoretical rate of interest where the economy is in balance with full employment and stable prices. The concept has been central to discussions about monetary (and, increasingly, fiscal) policy in recent years, but discovering the level is challenging/impossible, and the premise itself has been called into question.

The neutral rate can't be directly observed, so estimating it relies on a lot of assumptions. But if we accept the premise, there is agreement that the neutral rate has decreased significantly. A recent Fed paper estimated that the neutral rate of interest is around negative 2 percent, which effectively means that monetary policy setting nominal rates above 0 percent would be restrictive. And if the Fed were to follow its traditional recession playbook and cut nominal rates to ~4 percentage points below the neutral rate, it would have to lower the fed funds rate to negative 4 percent.

Discussions about the neutral rate are interesting because they're central to how central bankers try to manage the economy, but also because they're a useful component for understanding the overlap between fiscal and monetary policy. Part of the reason Powell and virtually every Fed official are begging Congress to spend more is because they realize cutting rates below zero is risky, and the consensus is that when the natural rate is negative, government spending is the best way to direct money to the right channels (e.g., households that need money and will spend it) and has the helpful side effect of increasing the natural rate of interest (e.g., public spending creates more consumer demand, which leads to greater prospective returns on investment, which increases business confidence and investment, raising r star).

Williams provides a good summary of the way the IMF and other authorities use this concept, as well as providing a defense of the establishment view. Here's a question from Joe about the ideology embedded within the equations economists use and the resulting implicit bias.

Q: "What do you make of the critique that there is an anti-government spending, anti-labor ideology embedded in this, which then translates into actual policies of raising the interest rate too soon even though we're not at full employment, or raising the interest rate in response to stimulus, to blunt the effects of fiscal policy. Basically, [what do you make of the critique that] what appears to be science and math is really politics?"

A: "I'm a little skeptical that economists have this deep-seated conservative bias and view of the world... A lot of heterodox people think about the classic theories of econ from the 60s and 70s, with perfect markets and everything's in equilibrium all the time... But when you look around at cutting-edge econ in any field ... it doesn't really make those sorts of assumptions anymore ... If there is a deep-seated intellectual bias inside of us, my coauthors and I weren't particularly aware of it."

On the other hand, the workhorse models that are still used by government agencies, central banks, and think tanks still generally come with assumptions -- such as zero unemployment, perfectly competitive markets, perfect foresight, perfect rationality, perfect cooperation, taxes are distortionary and create deadweight loss, public investment is wasteful, transfer programs transfer no benefits, capital markets are perfect -- that result in a pretty strong bias against public programs. Ad hoc additions have been made, but the "familiar refrain of neoclassical economics about tax distortions, crowding out, and regulatory rigidities" remains embedded in most economic models used to evaluate policy.

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