Bleak future?

This article appears in the December 7, 2015 issue of National Review.

Interest rates have been so low for so long that younger readers of National Review might wonder why anyone would ever bother to put money in a bank account or invest in a bond. This lengthy period of low interest rates is of course partly attributable to pricefixing in bond markets. The Federal Reserve has kept its key policy variable, the federal-funds rate, close to zero for nearly seven years. But as the world economy inches back toward normal, and the Fed does likewise, it is natural to inquire, “What is a normal interest rate?” There is a chance, after all, that we might observe one again someday.

Many attribute the introduction of the notion of a long-run rate of interest to Swedish economist Knut Wicksell’s 1898 essay “The Influence of the Rate of Interest on Commodity Prices.” In the years since, economists have studied the concept at length, and, as with the more widely recognized concept of the natural rate of unemployment, it has become a key consideration for policymakers. In the long run, economists assume, the labor market is at the natural rate of unemployment, and in the long run the interest rate is at its natural or “equilibrium” real rate as well.

Since 2012, the Federal Reserve has published the long-term interest-rate forecasts of the individual members of the Federal Open Market Committee (FOMC). It publishes this set of economic projections alongside many others, such as those for growth and inflation. While these receive little focus, they provide citizens with the predictions of a sophisticated group about something conceptually similar to the natural rate of interest.

As can be seen in the chart, the average FOMC forecast for the longer-run interest rate at the time of the first data release in January 2012 was 4.20 percent. As of the last data release this past September, it had fallen to 3.46 percent.

This drop is extremely noteworthy but has scarcely received attention. How should one interpret this reduction of the long-run interest-rate forecast? The macroeconomics literature on the topic points to one conclusion: The Fed has increasingly become very, very, very gloomy about the future of economic growth.

There are two main channels that associate lower rates of interest with lower growth. The first comes from businesses and the second from consumers. As the level of expected economic activity decreases, businesses ratchet down their investment plans, reducing the demand for credit. As consumers expect lower growth, they save more today to preserve their standard of living in the future. Both effects link lower growth to lower interest rates.

And if the FOMC members are reducing their forecasts for the interest rate over the long run, abstracting away from the influence of temporary shocks, then they are anticipating that the current gloom will persist. The minutes of the most recent FOMC meeting, in Sep tember, corroborate this view. “The [Federal Reserve] staff left its forecast for real GDP growth over the second half of the year little changed but lowered its projection for economic growth over the next several years. The staff also further trimmed its assumptions for the rate of increase in productivity and potential output over the medium term,” the most recent round of released minutes noted.

Apparently, in the minds of the FOMC, the U.S. economy is running on fumes. Could the Fed turn out to be wrong? For that to happen, productivity would have to surprise on the upside, driving up firms’ demand for credit and reducing the savings of investors. The good news is that if these figures returned to normal levels, a textbook model would yield a natural interest rate at least a percentage point or two above the current Fed projection. The bad news is that growth has disappointed so much for so long that the Fed’s pessimism is not clearly irrational. The euro–dollar futures market allows us to calculate what the market thinks the long-run natural rate of interest is, and it is below even the Fed’s current forecast—by a full percentage point. It’s hard to imagine sentiment being any darker, which perhaps suggests impending dawn.

from AEI » Latest Content http://ift.tt/1jK0Cax