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.