Even The Fed Admits The "Natural" Rate Of Interest Is Lower Than Markets Are Pricing

Tyler Durden's picture

One of the most important, but difficult to measure, concepts in macroeconomics is the natural or equilibrium real interest rate. This is the rate of interest consistent with full employment and stable inflation. The last few weeks have seen bond yields tumble and a rising cacophony of market participants questioning both the Fed's central tendency of terminal or natural rates (around 4%) and the market's perception of how fast we get there. SF Fed Williams models see a 1.8% natural rate, BofA also believes it is between 1.5 and 2%; and now Citi admits, "fair value of long-term rates may be lower than we and other market participants judged them to be."

As BofA explains,

The natural rate is unobservable and varies considerably over time. In particular, it tends to be low during recessions and high during recoveries. However, over the long term, it tends to gravitate toward a slowly evolving normal level. Thus, it is useful to think of both a shortterm natural rate—the level needed to counter short term shocks — and the longterm natural rate—the level once the economy settles down. Pin-pointing the natural rate is important because it helps us gauge how stimulative current monetary policy is, and it helps forecast how far the Fed will eventually hike rates.

Recently, a number of analysts have suggested that the natural rate is much lower today. They point to the low average rates of the last decade. They note that the current period may be similar to the pre-Volcker years of low real rates. They also argue that the drop in trend growth in the economy may mean a lower natural rate. According to our rates team, this talk of a lower natural rate has helped push long-run market expectations for the nominal funds rate down to just 3%. Assuming the Fed hits its 2% inflation target, this implies just a 1% real rate. Here, we take a close look at the natural real rate in both theory and practice and argue that the market has probably overshot a bit. Our tentative bottom-line: the real natural rate has dropped from an historic average of about 2% to 1 ½%.


A common view among analysts is that “according to growth theory, in the longrun, the real rate of interest should equal trend growth in GDP.”


So much for the theory, what about practice? The simplest way to measure the natural rate is to average interest rates over long periods of time, smoothing out short-term swings related to recessions and other shocks. While we can get data on short-term interest rates going back into the 1800s, we focus our analysis on the period since 1960. Capital markets are very different today than in the pre-war period, and the earlier periods featured some huge swings in real short-term interest rates (Chart 7). Real rates surged in the Depression when inflation went deeply negative and then collapsed during and after World War II when inflation spiked but interest rates were fixed by the US Treasury. These extended outlier periods tell us little about the natural rate.

Chart 8 shows “ex post” real rates over the last 55 years.

Finally, there is also an active academic literature on the natural rate. In the most commonly cited paper, Laubach and Williams (L&W) have estimated the natural funds rate in a simple macro model. The model includes three equations and two “gap variables”: (1) GDP growth depends on its own lags and the deviation of the real funds rate from its natural level; (2) inflation is determined by the gap between actual and potential GDP (i.e. the output gap); and (3) potential GDP growth and the natural real funds rate both depend on growth in productivity.

In the original paper-back in 2003, L&W found that the natural rate varied from a high of about 4.5% in the mid-1960’s to a low of 1.25% in the early 1990s, but had rebounded to about 3% at the time of the writing. They also found the natural rate did vary roughly one-for-one with potential growth, but that most of the variation in the natural rate came from other factors in their model.

More recently, L&W have updated their estimates, and the results are eyepopping: the natural rate has tumbled to -0.2% in 4Q of last year (Chart 9). If true, this has big implications for the economy and bond markets.

Before investors pour all of their money into the bond market, however, it is important to take these results with a grain of salt. As the authors admit, the uncertainty around their estimates is “sizable”.

FOMC members are in the process of revising their own views of the natural rate. Four times a year, each member submits funds rate forecasts for the next few years and for the “longer run”. Presumably the “longer run” corresponds to their estimate of the nominal natural rate—the sum of the real natural rate and the Fed’s 2% inflation target. This “dot plot” has been drifting lower since it was introduced in January 2012 (Chart 10).

The debate at the Fed has shifted lower with “hawks” abandoning the 4.5% projection and “doves” moving down to 3.5%. Recall that one of those dots is San Francisco Fed President John Williams—he’s the “W” in “L&W”. His model suggests a 1.8% nominal natural rate. And yet the lowest “dot” is 3.5%, and he has not offered an estimate in his public speeches.

BofA's ominous conclusion...

Unless the US is going down the “Japan path” of chronic malaise, higher rates are just a matter of time.

That could never happen here.. right? Of course none of this should a surprise after Ben Bernanke himself said interest rates would not normalize to those historicl levels in his lifetime...

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TheRideNeverEnds's picture

But wait a minute.... I though rates went up during good times?!  How is this possible during the summer of recovery?

Antifaschistische's picture

Who wrote this article.   The "natural" rate of interest would be the rate of interest priced on individual debt instruments based on risk WITHOUT the FED pumping bond prices through the ceiling and supressing rates.   We can't have a "natural" rate with the FED.  That's notion is a scam.

If you want to know what the natural rate would be....the close the discount window and cease all FED debt procurement.   voila.   Stop theorizing...and just do it and see what happens.


Carl Popper's picture

To find the natural rate would require a free market with neither buyers nor sellers of debt being of sufficient size to influence pricing.



Lol.   Like that will ever happen

Frilton Miedman's picture

Regardless of stance on whether Fed QE is appropriate, this is true.


NotApplicable's picture

Welcome to the "New Natural." Please do not worry, but rather, prepare to muddle-through.


NidStyles's picture

If the fed isn't buying debt, no one would. When the fed stops, the musics stops, the lights turn on, and the party is over. 

Bloody Muppet's picture

And you notice your slim, attractive dance partner is actually Jocelyn Wildenstein.

SAT 800's picture

Who wrote this article? an un-educated moron.

SAT 800's picture

Fraudulent premise; false definition of natural rate of interest. therefore entire article useless and un-readable; sorry; moving on.

LetThemEatRand's picture

This is kind of like an armed robber admitting that liquor store employees don't always hand over what's in their cash register to customers.

Bay of Pigs's picture

Lies and garbage. No need for ZH to post this propaganda anymore. Nobody believes it.

Chupacabra-322's picture

Lower? Or in the Negative?

kaiserhoff's picture

Complete horse shit.

The way to determine "natural" rates is for the Fed to get out of the way and let a free market decide.

rtalcott's picture

"...The natural rate is unobservable and varies considerably over time...."

People are paid to write this?

Carl Popper's picture

The natural rate would be easily observable with proper market conditions.  As easy to observe as the spot price of wheat or pork bellys.

NOTaREALmerican's picture

Like, OMG,  haven't these guys factored in that everybody is above average now?

I Write Code's picture

Um, wtf are we talking about, annual inflation/deflator?

Why is that natural?  No antibiotics were used in its production?  No insecticides or chemical fertilizers were in the coffee machine?  wtf, man.

infinity8's picture

I'm glad to see so many call BS on this. w.o.w.

Bluntly Put's picture

If they just let the markets set interest rates, they wouldn't have to bloviate for years about what the sweet spot interest rate was.


Carl Popper's picture

It is funny that something that could be so simple to measure in the right circumstances has been intentionally made difficult.


On second thought it isnt funny if you understand the implications.

JR's picture

Markets, true markets, set the interest rate, not bankers. And to gather together a group of bankers suggesting what the natural rate is is a disgrace.

Maybe the investors as a group should determine what the natural profit for bankers should be.

The Fed is using a lever to lower interest rates to entice people back into the banks to borrow money so as to reverse any trend toward private capital formation. Debt is the bankers' lifeblood.

The Fed has cracked the foundations of the private market economy that supported the American nation, now tilting toward collapse. It has pulled the wool over the sheeples' eyes using the sleight of hand of "Keynesianism," a pretend science that in realilty is a gigantic scam perpetrated upon the people.

What America needs is for these failed bankers to keep their hands out of the nation's economic pot.

Economist Henry Hazlitt tells us that if a mathematical equation is not precise, it is worse than worthless; it is a fraud:

It gives our results a merely spurious precision. It gives an illusion of knowledge in place of the candid confession of ignorance, vagueness, or uncertainty which is the beginning of wisdom.

Murray Rothbard in Economic Depressions: Causes & Cures writes:

“The Misesian prescription (for curing a depression) is the exact opposite of the Keynesian: It is for the government to keep absolute hands off the economy, and to confine itself to stopping its own inflation, and to cutting is own budget.”

What the country really needs now is not more government stimulus spending and Fed QE but more authentic saving based on market rates in order to validate some of the excessive Fed largesse that is pumping up the stock market bubble.

Americans must abolish the Fed and let market adjustment once again do the work for a sound economic recovery and economic justice.

truthseek3r's picture

How can anything be natural given the Fed's clear & obvious manipulations? This article belongs on mainstream economic website but not ZeroHedge who atleast tries to tell it like it is.

Dre4dwolf's picture

All mortgages should be hovering around 1.2 % at the very least ... banks are fucking choking on free money and they are still greedy, lets just hope no one performs the heimlich maneuver this time around . . . 





What comes next is great.



JailBanksters's picture

The Banks getting money for nuttin and your paying 13%+ on your card


nostromo17's picture

"Natural Rate" complete hogwash. We live in a time of unnatural acts of rate supression -artificially low rates. So discussing "Natural Rates" is meaningless garbage especially in this context and pretty much any other context. Rates are among the least "natural" thing in the universe. What are now Deists?

Rates should be set by some form of pricing risk,naturally, which they are not. A rate spectrum goes with a risk environment spectrum. Why use the concept of a "Natural Rate" at all, its just obfuscation? More pretending anyone that talks about the economy in the media has some clue or that economics in the main stream is scientific somehow and not just a tool of the ruling class disinformation process.

Lets all ignore the slow motion unwind of deflation. Since 9/11 when all the bonds got lost for a while thanks to Bank of New York and under the subsequent guidance of voodoo economists believing for absolutely no reason %2 rates made sense and Thatcher et al(when in effect we have lingered in an environment of Zero, Goose Egg, rates or negative rates once inflation is cast across the scene)there has been and will not be any "growth."

A bunch of more pathetic bunch idiots has never been seen in history.

Growth requires credit which implies risk which certainly implies higher than %2 rates.

These fools that call themselves economists are really telling us its the end of the world, that there will be no growth only contraction and ultimately deflation. And so doing they rationalize their rationalization. Its a spiral of bullshit. Low inflation protects savings -- not if the world falls apart and you can't buy anything. Low rates allow the government to control debt, well what about the rest of us. Each stupid rationalization is just a truncated half idea taken out of the context of whole economy and out of the context of anything that remotely makes sense.

And this really serves NO ONE. The pie is shrinking. A few monopolies consolidate to make a very few wealthy in the short run of a generation or so. Wealth to live surrounded by the anguish terror and poverty that will surround them. All for no reason.

When you subtract the about %1 advantage of be the "flight to quality" bond source and the privelege of being the main global currency we have probably been under zero rates since at least 9/11. Contraction - how do you like it?

JR's picture

@ A few monopolies consolidate to make a very few wealthy in the short run of a generation or so. – nostromo17

Why Can't We Access the Fed's Free Money?

Monday, 09 December 2013 13:23 By Ellen Brown, Web of Debt | Op-Ed

December 23rd marks(ed) the 100th anniversary of the Federal Reserve. Dissatisfaction with its track record has prompted calls to audit the Fed and end the Fed. At the least, Congress needs to amend the Fed, modifying the Federal Reserve Act to give the central bank the tools necessary to carry out its mandates.

The Federal Reserve is the only central bank with a dual mandate. It is charged not only with maintaining low, stable inflation but with promoting maximum sustainable employment. Yet unemployment remains stubbornly high, despite four years of radical tinkering with interest rates and quantitative easing (creating money on the Fed’s books). After pushing interest rates as low as they can go, the Fed has admitted that it has run out of tools.

At an IMF conference on November 8, 2013, former Treasury Secretary Larry Summers suggested that since near-zero interest rates were not adequately promoting people to borrow and spend, it might now be necessary to set interest at below zero. This idea was lauded and expanded upon by other ivory-tower inside-the-box thinkers, including Paul Krugman.

Negative interest would mean that banks would charge the depositor for holding his deposits rather than paying interest on them. Runs on the banks would no doubt follow, but the pundits have a solution for that: move to a cashless society, in which all money would be electronic. “This would make it impossible to hoard cash outside the bank,” wrote Danny Vinik in Business Insider, “allowing the Fed to cut interest rates to below zero, spurring people to spend more.” He concluded:

. . . Summers’ speech is a reminder to all liberals that he is a brilliant economist who grasps the long-term issues of monetary policy and would likely have made an exemplary Fed chair.

Maybe; but to ordinary mortals living in the less rarefied atmosphere of the real world, the proposal to impose negative interest rates looks either inane or like the next giant step toward the totalitarian New World Order. Business Week quotes Douglas Holtz-Eakin, a former director of the Congressional Budget Office: “We’ve had four years of extraordinarily loose monetary policy without satisfactory results, and the only thing they come up with is we need more?”

Paul Craig Roberts, former Assistant Secretary of the Treasury, calls the idea “harebrained.” He is equally skeptical of quantitative easing, the Fed’s other tool for stimulating the economy. Roberts points to Andrew Huszar’s explosive November 11th Wall Street Journal article titled “Confessions of a Quantitative Easer,” in which Huszar says that QE was always intended to serve Wall Street, not Main Street.  Huszar’s assignment at the Fed was to manage the purchase of $1.25 trillion in mortgages with dollars created on a computer screen. He says he resigned when he realized that the real purpose of the policy was to drive up the prices of the banks’ holdings of debt instruments, to provide the banks with trillions of dollars at zero cost with which to lend and speculate, and to provide the banks with “fat commissions from brokering most of the Fed’s QE transactions.”

A Helicopter Drop That Missed Its Target

All this is far from the helicopter drop proposed by Ben Bernanke in 2002 as a quick fix for deflation. He told the Japanese, “The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” Later in the speech he discussed “a money-financed tax cut,” which he said was “essentially equivalent to Milton Friedman’s famous ‘helicopter drop’ of money.” Deflation could be cured, said Professor Friedman, simply by dropping money from helicopters.

But there has been no cloudburst of money raining down on the people. The money has gotten only into the reserve accounts of banks. John Lounsbury, writing in Econintersect, observes that Friedman’s idea of a helicopter drop involved debt-free money printed by the government and landing in people’s bank accounts. “He foresaw the money entering the economy through bank deposits, not through bank reserves which was the pathway available to Bernanke. . . . [W]hen Ben Bernanke fired up his helicopter engines he took the only path available to him.”

Bernanke created debt-free money and bought government debt with it, returning the interest to the Treasury. The result was interest-free credit, a good deal for the government. But the problem, says Lounsbury, is that:

The helicopters dropped all the money into a hole in the ground (excess reserve accounts) and very little made its way into the economy.  It was essentially a rearrangement of the balance sheets of the creditor nation with little impact on the debtor nation.

. . . The fatal flaw of QE is that it delivers money to the accounts of the creditors and does nothing for the accounts of the debtors. Bad debts remain unserviced and the debt crisis continues.

Thinking Outside the Box

Bernanke delivered the money to the creditors because that was all the Federal Reserve Act allowed. If the Fed is to fulfill its mandate, it clearly needs more tools; and that means amending the Act.  Harvard professor Ken Rogoff, who spoke at the November 2013 IMF conference before Larry Summers, suggested several possibilities; and one was to broaden access to the central bank, allowing anyone to have an ATM at the Fed.

Rajiv Sethi, Barnard/Columbia Professor of Economics, expanded on this idea in a blog titled “The Payments System and Monetary Transmission.” He suggested making the Federal Reserve the repository for all deposit banking. This would make deposit insurance unnecessary; it would eliminate the need to impose higher capital requirements; and it would allow the Fed to implement monetary policy by targeting debtor rather than creditor balance sheets. Instead of returning its profits to the Treasury, the Fed could do a helicopter drop directly into consumer bank accounts, stimulating demand in the consumer economy.

John Lounsbury expanded further on these ideas. He wrote in Econintersect that they would open a pathway for investment banking and depository banking to be separated from each other, analogous to that under Glass-Steagall. Banks would no longer be too big to fail, since they could fail without destroying the general payment system of the economy. Lounsbury said the central bank could operate as a true public bank and repository for all federal banking transactions, and it could operate in the mode of a postal savings system for the general populace.

Earlier Central Bank Ventures into Commercial Lending

That sounds like a radical departure today, but the Fed has ventured into commercial banking before. In 1934, Section 13(b) was added to the Federal Reserve Act, authorizing the Fed to “make credit available for the purpose of supplying working capital to established industrial and commercial businesses.” This long-forgotten section was implemented and remained in effect for 24 years. In a 2002 article on the Minneapolis Fed’s website called “Lender of More Than Last Resort,” David Fettig noted that 13(b) allowed Federal Reserve banks to make loans directly to any established businesses in their districts, and to share in loans with private lending institutions if the latter assumed 20 percent of the risk. No limitation was placed on the amount of a single loan.

Fettig wrote that “the Fed was still less than 20 years old and many likely remembered the arguments put forth during the System’s founding, when some advocated that the discount window should be open to all comers, not just member banks.” In Australia and other countries, the central bank was then assuming commercial as well as central bank functions.

Section 13(b) was eventually repealed, but the Federal Reserve Act retained enough vestiges of it in 2008 to allow the Fed to intervene to save a variety of non-bank entities from bankruptcy. The problem was that the tool was applied selectively. The recipients were major corporate players, not local businesses or local governments. Fettig wrote:

Section 13(b) may be a memory, . . . but Section 13 paragraph 3 . . . is alive and well in the Federal Reserve Act. . . . [T]his amendment allows, “in unusual and exigent circumstances,” a Reserve bank to advance credit to individuals, partnerships and corporations that are not depository institutions.

In 2008, the Fed bailed out investment company Bear Stearns and insurer AIG, neither of which was a bank. Bear Stearns got almost $1 trillion in short-term loans, with interest rates as low as 0.5%. The Fed also made loans to other corporations, including GE, McDonald’s, and Verizon.

In 2010, Section 13(3) was modified by the Dodd-Frank bill, which replaced the phrase “individuals, partnerships and corporations” with the vaguer phrase “any program or facility with broad-based eligibility.” As explained in the notes to the bill:

Only Broad-Based Facilities Permitted. Section 13(3) is modified to remove the authority to extend credit to specific individuals, partnerships and corporations. Instead, the Board may authorize credit under section 13(3) only under a program or facility with “broad-based eligibility.”

What programs have “broad-based eligibility” is not clear from a reading of the Section, but it isn’t individuals or local businesses. It also isn’t state and local governments.

No Others Need Apply

In 2009, President Obama proposed that the Fed extend its largess to the cash-strapped cities and states battered by the banking crisis. “Small businesses and state and local governments are having serious difficulty obtaining necessary financing from debt markets,” Obama said. He proposed that the Fed buy municipal bonds to cut their rising borrowing costs.

The proposed municipal bond facility would have been based on the Fed program to buy commercial paper, which had almost single-handedly propped up the market for short-term corporate borrowing. Investors welcomed the muni bond proposal as a first step toward supporting the market.

But Bernanke rejected the proposal. Why? It could hardly be argued that the Fed didn’t have the money. The collective budget deficit of the states for 2011 was projected at $140 billion, a drop in the bucket compared to the sums the Fed had managed to come up with to bail out the banks. According to data released in 2011, the central bank had provided roughly $3.3 trillion in liquidity and $9 trillion in short-term loans and other financial arrangements to banks, multinational corporations, and foreign financial institutions following the credit crisis of 2008. Later revelations pushed the sum up to $16 trillion or more.

Bernanke’s reasoning in saying no to the muni bond facility was that he lacked the statutory tools.. The Fed is limited by statute to buying municipal government debt with maturities of six months or less that is directly backed by tax or other assured revenue, a form of debt that makes up less than 2% of the overall muni market.

The Federal Reserve Act was drafted by bankers to create a banker’s bank that would serve their interests. It is their own private club, and its legal structure keeps all non-members out.  A century after the Fed’s creation, a sober look at its history leads to the conclusion that it is a privately controlled institution whose corporate owners use it to direct our entire economy for their own ends, without democratic influence or accountability.  Substantial changes are needed to transform the Fed, and these will only come with massive public pressure.

Congress has the power to amend the Fed – just as it did in 1934, 1958 and 2010. For the central bank to satisfy its mandate to promote full employment and to become an institution that serves all the people, not just the 1%, the Fed needs fundamental reform.

Ellen Brown

Ellen Brown is an attorney, president of the Public Banking Institute, and author of twelve books including the best-selling Web of Debt. In The Public Bank Solution, her latest book, she explores successful public banking models historically and globally. Her websites are Web of Debt, Public Bank Solution, and Public Banking Institute.


khakuda's picture

It is nonsense to use the Fed's own fake measure of inflation, the core PCE, to justify that rates should be below normal.  If we used CPI the way it was calculated even a decade or two ago, one would not reach the same conclusion.  Real growth probably is lower because of the debt overhang, but inflation is not measured properly on purpose.  I don't know anyone who sees their rent going up 4% a year, healthcare costs or tuition bills rising near double digits believing that lie.

The unstated policy of the Federal Reserve is to create a massive stock market and credit bubble to create inflation to debase the debt, that is why they are justifying leaving rates low.   All of their original reasons for keeping rates at zero and doing QE are gone, yet they continue.  Stocks are back to very full valuations, Spain, Italy and the like can borrow at all time record low rates, junk debt is frothy as hell, etc.  That is why the Fed keeps changing the bar for raising rates over and over again.  Krugman let the truth out a decade ago after the late 90s stock market bubble when he said, "We need a real estate bubble now to bail us out."  They are trying to create a super bubble like no one has ever seen.

That is all this is about.  Let's all look forward to record highs in equity markets and sovereign debt again next week.

JR's picture

Kudos, nostromo17 and khakuda, for unraveling the confusing array of complicated nonsense (lies) the Fed has woven around the market in order to confuse and repel the typical citizen – the non-economist – so he’ll simply “leave it to the experts.” These “experts,” of course, are invariably the proponents of expanding government power by manipulating the private economy.

In a recent interview with Mike Whitney, Paul Craig Roberts explains how the Fed has backed itself into a corner, perhaps deliberately as a ruse, in my opinion, to cripple U.S. middle-class monetary might while it pushes nations into the one-world currency of banker totalitarianism – the IMF’s SDR.  However, I believe this may be too late; Fed credibility is now so low that world government is virtually impossible except by brute force – as is being applied in Ukraine.

Here’s Roberts and the truth regarding interest rates:

“[C]entral banks and some investors have realized that the Federal Reserve is locked into the policy of supporting bond prices. If the Federal Reserve ceases to support bond prices, interest rates will rise, the prices of debt-related derivatives on the banks’ balance sheets will fall, and the stock and bond markets would collapse. Therefore, a tapering off of quantitative easing risks a financial panic.

“On the other hand, continuing the policy of supporting bond prices further erodes confidence in the US dollar. Vast amounts of dollars and dollar-denominated financial instruments are held all over the world. Holders of dollars are watching the Federal Reserve dilute their holdings by creating 1,000 billion new dollars per year. The natural result of this experience is to lighten up on dollar holdings and to look for different ways in which to hold reserves.

“The Federal Reserve can print money with which to purchase bonds, but it cannot print foreign currencies with which to purchase dollars. As concerns over the dollar rise, the dollar’s exchange value will fall as more dollars are sold in currency markets. As the US is import-dependent, this will translate into higher domestic prices. Rising inflation will further spook dollar holders.