Monday, August 9, 2010

Inflation Targeting When the Natural Interest Rate is Negative

Over a century ago, in a theory that is still influential today, Swedish economist Knut Wicksell argued that, at any particular time, there is a certain “natural rate of interest” that is consistent with price stability. If the actual rate of interest falls below the natural rate, there is an incentive for entrepreneurs to borrow aggressively and demand more goods and more labor, driving prices up. If the actual rate rises above the natural rate, the incentive to borrow disappears, leading entrepreneurs to demand less goods and labor, driving prices down. Since the opportunities available to entrepreneurs are always changing, the natural rate is always changing, sometimes rising dramatically and at other times falling dramatically. Thus Wicksell argued that, relative to the natural rate, “the interest on money is, in reality, very often low when it seems to be high, and high when it seems to be low.”

As applied to the world we live in today, Wicksell’s original theory has several shortcomings, all widely recognized now. First, it doesn’t account for stickiness in wages and prices: as we observe, the short-run effect of a drop in demand is not so much a fall in wages and prices as a fall in employment. Second, it doesn’t account for the role of expectations in determining the price level and thus, the possibility of “inertial” inflation: it is now generally understood that (under a fiat money regime) a steadily rising price level, rather than a necessarily constant price level, is consistent with the equilibrium “natural” interest rate that Wicksell hypothesized. Third, it doesn’t fully account for the role of inflation expectations in defining the “real” interest rate: for example, a 2% nominal interest rate when prices are expected to be constant is equivalent to a 4% nominal interest rate when prices are expected to rise at a 2% rate. Finally, as I discuss below, it doesn’t account for the role of risk aversion in determining the behavior of entrepreneurs and those who finance them.

Wicksell argued that the natural interest rate was determined by the rate of return on capital. But in practice, the rate of return on capital is never known exactly in advance. Entrepreneurs require a compensation for the risk involved, and lenders (and buyers of stock and other forms of financing) require a compensation for the risk involved in financing them. As a result, particularly in times which are uncertain and when people are particularly risk-averse, there can be a very large wedge between the natural “risk-free” rate of interest and the rate of return on capital. One consequence of having such a large wedge is that, even if the return on capital is necessarily expected to be positive, the natural interest rate can be negative.

When the natural interest rate is negative, since it’s impossible to cut nominal interest rates much below zero, the only way to get back to normal is to create an expectation of inflation. If the nominal interest rate is zero and the inflation rate is positive, then the real interest rate is negative; thus it is possible, with a sufficient amount of expected inflation, to set the real interest rate down to the negative natural rate. But how can that inflation be achieved? Wicksell argues that prices rise when the actual interest rate falls below the natural rate, but in order for that to happen, prices must already be expected to rise. Can a central bank pull itself up by its own bootstraps?

The answer is almost certainly yes, since nearly everyone agrees that a sufficiently reckless central bank will always be able to produce a high inflation rate. (Imagine the Fed buying up the entire national debt, along with all the private sector’s offerings of commercial paper, mortgages, corporate bonds, and so on. Eventually, there will be inflation.) The problem is that it is hard to estimate in advance how aggressive monetary policy needs to be in order to produce the needed expectation of inflation. Not only doesn’t the central bank know what actions would produce a given “happy medium” target between too-low and too-high inflation expectations; it never really even knows what the natural interest rate is, so it doesn’t know how much inflation would be enough to get the real rate down to the natural rate.

If the central bank estimates wrong and overshoots, it risks a period of very high, and unnecessarily high, inflation. If (as seems infinitely more likely to me) it estimates wrong and undershoots, it risks reducing its credibility, so that it becomes more difficult, subsequently, to achieve the necessary inflation rate. (Note BTW that if you take the Mankiw Rule as an estimate of the natural interest rate, then the Fed’s current 2% inflation target is not high enough: the Fed is on a course to fail and thereby reduce its subsequent credibility.)

The solution is to aim not for an inflation rate but for a price level (or, as I suggested in my previous post, a level of nominal GDP). A series of price level targets that rises over time, but that does not get revised when the central bank undershoots or overshoots, allows for policy that automatically becomes more aggressive (or less aggressive) as necessary. If the central bank undershoots the first price level target, the second target is still in place, and this means it must aim for a higher inflation rate. If it undershoots the second target, the third is still in place, and it must aim for yet a higher inflation rate. And so on. Eventually, it will (automatically) find the inflation rate that works.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.


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