What is the natural rate of interest? This is one question prompted by the fact that both the Bank of England and US Federal Reserve will promise next week to keep interest rates near zero for a long time.
The natural rate can be defined as the real interest rate at which output is at its potential level and at which inflation is stable. Right now, central banks want actual rates to be below this rate, in order to boost output and raise inflation.
Hence the question: what is the natural rate? We cannot see it directly*. But it has fallen since the 90s. We know this because actual real interest rates have trended downwards without stimulating significantly higher real growth or inflation. Economists variously attribute this to the declining rate of profit, an ageing population or a decline in innovation.
What’s more, economists at the Dutch National Bank have shown that lower natural rates – insofar as they reduce actual interest rates – can be self-fulfilling. Low interest rates help to keep inefficient companies – so-called zombie firms – in business. This retards the creative destruction which is necessary for economic growth. And in reducing growth, so the natural rate of interest falls further, causing a vicious circle.
The pandemic might have pushed the natural rate down further. In creating uncertainty it could raise both household and corporate savings and depress innovation. These might be long-lasting effects: we know, from the work of Ulrike Malmendier, that recessions can have permanent effects upon our appetite for risk. If so, we should expect lower economic activity at any given interest rate – which means a lower natural rate of interest. A team of economists at the University of California at Davis has shown that, partly because of this, pandemics have in the past reduced the natural rate of interest a lot.
There are, though, offsets to this. In disturbing patterns of demand, the pandemic might reduce potential output – if (say) unemployed baristas cannot quickly move into occupations seeing increased demand. This would raise the natural rate because it would raise inflation by generating labour shortages. This, though, should be only a temporary effect.
Also, higher government borrowing should raise the natural rate of interest simply by raising aggregate demand. Which is why an early fiscal tightening is so dangerous for savers: it would hold down returns on our savings even more for even longer.
This danger, though, merely reinforces those that arise from the risk that the pandemic will reinforce long-established downward pressures upon the natural rate of interest. If so, ultra-low rates might not do much to stimulate growth or inflation – which central banks will regard as a reason for keeping them low for even longer.
Yes, this is a grim prospect for all of us savers. We should not, however, blame central banks for it. Instead, the problem lies in emergent features of western economies which goverments have not successfully ameliorated.
* In this respect it is like many other concepts in conventional economics, such as the natural rate of unemployment, marginal utility, marginal product or even the capital stock. You might think a dependence upon so many unobservable entities brings conventional economics into question. I’d agree.
