...against fictions and other tall tales

Monday 30 March 2015

Ben Bernanke and the natural rate of interest

From Professor Bernanke to Governor Bernanke to Chairman Bernanke to Ben Bernanke, Blogger. Quite the progression!

I enjoyed reading Ben Bernanke's blog post today. But it doesn't appear everyone thinks like me. I noticed some have criticized Bernanke for using the concept of the equilibrium (or natural) rate of interest, or the real rate of interest consistent with output at its potential level and with stable prices.

Now, I realize that the equilibrium real rate is unobservable and varies through time, which means it's subject to uncertainty. However, we could say the same thing about the concept of potential output, yet few would deny it is a useful concept.

In fact, most people are aware of the concept of "output gap", the difference between potential output and actual output. The corollary concept for the real interest rate is the "interest rate gap", the deviation of the actual policy rate from the real equilibrium rate.

This is essentially what Bernanke was driving at in his post today. Simply, the interest rate gap is a measure of the stance of monetary policy: a large (small) gap means monetary policy is loose (tight).

Back in the Keynesian era, policymakers used the concept of the "full employment surplus" (FES), or the budgetary surplus consistent with full employment, as a way to illustrate how the actual budget deficit wasn't being caused by a lack of tax revenue or out of control government spending but rather was caused by the weakness of the economy and the lack of output due to unemployed and idle resources. I view the interest rate gap in a similar way. Whereas the FES provided a useful measure of the stance of fiscal policy by highlighting the difference between the actual "surplus" (or negative surplus in the case of a deficit) and the FES, the interest rate gap provides a useful measure of the stance of monetary policy.

But don't get me wrong. In no way does any of this mean that central banks should be rigid in adjusting their policy rate to track the estimated equilibrium real rate.

As far as I'm concerned, central bankers should use their judgement and consider all information, not just their estimates of the real equilibrium rate and interest rate gap. For instance, if a central bank's estimate of the real equilibrium rate shows it is rising, yet inflation isn't, it may not be the right time to increase the policy rate.

Similarly, if a central bank's estimate of the equilibrium rate shows it is remaining stable, yet unemployment is rising, it may be entirely justified for the central bank to keep its policy rate at the same level or even to reduce it. I'm of the same view when it comes to the concept of the natural rate of unemployment: using it properly requires good judgement.

A final note on Bernanke's comment about how large deficits tend to increase the equilibrium real rate given that government borrowing diverts savings away from private investment. One thing I noticed is that Bernanke carefully added that this would occur "if everything else stays equal". In other words, this means he's not denying that a different (or even, opposite) effect could occur if other forces are at work.

For instance, the opposite effect could occur if budget deficits, by sustaining business activity, reduce default risk on corporate bonds and subsequently narrow the spread between the yields on corporate and government bonds, thus helping to reduce the cost of capital to the private sector. In such a scenario, budget deficits have effectively "crowded-in" private sector spending. I doubt Bernanke would deny that budget deficits could have such an effect.


  1. Circuit,

    "Divert savings" is erroneous whatever the scenario. In what scenario is "saving diverted"?

    1. I know you aren't against the use of the expression "loanable funds" because I recall you saying so in the past ("loanable funds theory" is a separate matter). In Bernanke's framework, govt borrowing represents an increase in govt demand for funds, which, all things equal, will raise the interest rate (bid up the interest rate on private sector securities) and reduce the funds flowing to the private sector, as investors rearrange their portfolio to seek possibly higher returns.

      Now, I actually prefer your take that govt deficits are the mirror of net lending, however, I think the whole debate is a distinction without a difference. I=S and the framing to explain how this is so, in my opinion, is a matter of preference.

    2. My preference for terminologies is a separate matter as in any case I think of the model known as the loanable funds theory as incorrect.

      "Bernanke's framework" is obviously wrong. Question is are you saying it is right? There is no "distinction without any difference."

      Look at the Bernanke's framework:

      "govt borrowing represents an increase in govt demand for funds, which, all things equal, will raise the interest rate (bid up the interest rate on private sector securities) and reduce the funds flowing to the private sector, as investors rearrange their portfolio to seek possibly higher returns."

      It is wrong in so many levels. Even if you bring in all complications such as asset allocation theory, it doesn't follow that there's a reduction in funds flowing to the private sector.

    3. Bernanke is just laying out the textbook version. I'm just saying that framing allows for any number of ways in which interest rates won't rise as a result of deficits. Bernanke himself alludes to it by including the expression "all things equal".

    4. Yeah I noticed your pointing out to his qualifier "all things equal". But even if I take that into account, as I mention in my first comment, what does it ever mean.

      The Fed can itself raise interest rates if there's a fiscal expansion leading to a rise in output. But it needn't. Bernanke himself points out how he has resisted critics and not increased but then goes on to talk about the natural rate. These two are inconsistent with each other.

      There's no saving diversion nor reduction in funds flowing to the private sector. Which scenario? How?

      I think you are unnecessarily defending him here. Bernanke has done some good things but that doesn't mean he is beyond any critique. Finally he is just peddling myths like this and also other ones like the "saving glut" theory.

    5. I'm just going to point out that you use the word "needn't" to describe how an expansion can increase interest rates. Also, in your recent post, you say that "there’s no reason for interest rates to **necessarily** rise because of large deficits".

      I think Bernanke would agree with your statement. He qualified it the same way you did, just from a different vantage point.

    6. Some strange reasoning here Circuit :).

      If you have some problem in my post point it. If there is no error, my correctness doesn't make Ben Bernanke's errors correct.

      The other point is that while qualifiers are fine (and one should always qualify), it does not mean that adding a qualifier makes a sentence correct.

      Is there some secret place in the US like "Area 51" where the funds are diverted to and hidden?

    7. I don’t know, perhaps it’s the same place where the portfolio decisions of investors following an increase in the supply of government bonds don’t have any upward impact on interest rates. :)

    8. Hence proved. You like his beard. :-p

    9. Yeah, he needs to stop thinking like Congress is out to get him...and I actually don't mind the beard ;)

    10. The basic point I'm making here is well explained in the Baumol, Blinder, Seccareccia macro textbook:

      "When it spends more than it takes in, the government must borrow the rest...The government must borrow the funds from the public. I tdoes so by selling bonds, which compete with corporate bonds and other financial instruments for the "available" supply of funds. As some savers decided to buy government bonds, the remaining investment funds will have to shrink. Thus, some private borrowers get crowded out of the financial markets as the government claims an increasing share of the economy's total saving".

  2. "Quite the progression." ha.

    I like this approach, in that you disagree with his theoretical framework, but do not get too excited about the phrasing he uses.

    I guess I will hop on the bandwagon later today with a response. My complaint about his deficit observation is that it appears fairly empty. If deficits raised the equilibrium rate, what about Japan? The issue from my view is that you could just as easily say that gremlins raise or lower the equilibrium real rate, and it might offer just as many useful predictions.

    1. Looking forward to your response. I'll just add that deficits in small open economies such as Canada have a moderate impact on interest rates as compared to a country such as the US. There's lots that can be said one this issue. In the 80s, there was a fear that the Reagan deficits would crowd out private sector investment. They didn't but one could say they "crowded out" net exports. But, again, all this I think would be implied in Bernanke's model.

  3. Depending on what government spends money on, the government can "crowd out" the private sector from access to real resources (such as labor, land, materials etc). But since such elements are left idle anyway because of inadequate aggregate demand levels as well as inappropriate distribution of AD within society, government has the moral and legal right to employ the aforementioned elements toward public purpose. Money-wise, however, it's just not true - since the fiscal deficit represents the net financial surplus of the nongovernment sector.

    1. Good comment. I agree, it should always about the real resource costs.

  4. great read! slightly above my level of knowledge on the topic! lead here by a friend and I feel as though I can definitely use this as a tool to increase my understanding of economics


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