Scott Sumner  

There's nothing natural about the natural rate of interest

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It's not clear what a term like 'natural' actually means. What are "natural foods" for instance? Are they foods free of natural pesticides? Free of artificial pesticides? Are they free of both natural and artificial pesticides? And what if the artificial pesticide is chemically identical to a natural pesticide? Does that matter?

Or consider climate change. What is the "natural" level of CO2? Is it the CO2 level assuming humans did not exist? Why not if bison did not exist, burping lots of methane? (Yes, I know, methane isn't CO2. But still . . . ) And if (let's assume, counterfactually) Native Americans had decimated bison herds 10,000 years ago, and affected methane levels, would that be artificial or natural? Are hunter-gatherer societies artificial or natural?

How about the price of oil; is there a "natural" price of oil? Would that be a price not distorted by government polices like price controls? How about taxes? And suppose the global oil market was highly competitive, with lots of private firms and no price controls and no taxes. Is that a natural price? Now add one state-owned oil company, say in Norway. Otherwise laissez-faire. Is the resulting oil price the "natural" free market global price, or is it set by the Norwegian government, which has the discretion to adjust oil output, and thus oil prices (but only a little bit, or by a lot but for a short time)?

And how about central banks, which have the discretion to adjust the monetary base, and hence short term interest rates (but only a little bit, or by a lot but for a short time)?

I see 'natural' as a term that does more to confuse than enlighten, and in that sense I agree with a recent post by Tyler Cowen (but not in every particular).

Wicksell regarded the natural rate as the one that led to price stability. Why price stability? Presumably because he thought price stability was the proper way of thinking about "macroeconomic stability" more broadly. Here's Tyler:

As Scott Sumner has pointed out, the older natural rate of interest used to truly be about price stability. Nowadays that has morphed into "two percent inflation a year." Yes a definition can be changed, but still I find that intellectual maneuver strange and it implicitly suggests there may be multiple natural rates of interest; neither "zero" nor "two" is a special number. There is also a blurring between the rate of inflation, the increase in the rate of inflation, the expected rate of price inflation, and so on.
Part of Tyler's objection can be addressed by switching to the natural real rate of interest, which may be unaffected by a shift from zero to 2% trend inflation (although perhaps not precisely.) But that doesn't address all of his objections. And it's even worse, as there is no particular reason to assume that either stable prices or stable inflation is consistent with macroeconomic stability. You need a model. And we don't have a model that everyone agrees upon. I prefer using the benchmark of stable NGDP growth, although even that can undoubtedly be improved upon. And I'd prefer stabilizing expected NGDP growth. Thus for me the most useful definition of the "natural rate of interest" is the path of actual interest rates if we assume that NGDP futures prices are stable along a path rising at 4% or 5% per year.

You don't have to agree with me, but I'd encourage Austrian readers not to make the same mistake as those dreamy-eyed environmentalists or health food nuts, who equate 'natural' and "untainted by human actions." That is, don't assume that a natural rate of interest is the rate in a society free of government interference. Wage and price stickiness is a thorny problem, and it doesn't magically go away in an idyllic libertarian utopia. Getting to a path of nominal spending that leads to reasonable macroeconomic equilibrium is a hard problem, or else we would have solved it long ago.

Here's Brad DeLong:

More important, however, in thinking about our present concern with the natural ("neutral") ("equilibrium") real rate of interest is knowledge of the historical path by which we arrived at our current intellectual situation. Alan Greenspan did it. On July 20, 1994, Alan Greenspan announced that the Federal Reserve was not a "Keynesian" institution, focused on getting the volume of the categories of aggregate demand-C, I, G, NX-right. He announced that the Federal Reserve was not a "Friedmanite" institution, focused on getting the quantity of money right. He announced that the Federal Reserve was now a "Wicksellian" institution, focused on getting the configuration of asset prices right:

. . .

Greenspan thus shifted the focus of America's macroeconomic discussion away from the level of spending and the quantity of money to the configuration of asset prices. In some ways this is no big deal: "Keynesian", "Friedmanite", and "Wicksellian" frameworks are all perfectly-fine ways to think about macroeconomic policy. They are different-some ideas and some factors are much easier to express and focus on and are much more intuitive in one of the frameworks than in the others. But they are not untranslateable-I have not found any point that you can express in one framework that cannot be more-or-less adequately translated into the others.

The point, after all, is to find a macroeconomic policy that will make Say's Law, false in theory, true enough in practice for government work. You can start this task by focusing your analysis first on either spending, or liquidity, or the slope of the intertemporal price structure.

This seems like a kind of strange way of thinking about things. I've always thought of interest rates and money supply targeting as two means to an end, two tools to achieve stable growth in total spending. But even if it is strange, it's actually pretty close to how I'd like the profession to think about things. That is, the Fed could target M, or it could target i, or it could target NGDP futures prices. I prefer the latter, which is the expected growth in total spending.

I tend to think Say's Law is either true or false, depending on how you think about it. (I.e., what you are holding constant.) But I much prefer DeLong's way of thinking about it, and I wish more Austrians would think about it this way. Maybe DeLong's aphorism is not literally true, but it brilliantly expresses a sort of poetic truth, as when Borges said:

India is larger than the world

HT: Marcus Nunes, TravisV.

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COMMENTS (23 to date)
James writes:

Arguing for an NGDP target is like arging for a minimum wage without specifying what that floor should be. If the central bank can target NGDP growth, the central bank still needs to identify an actual target.

How will they ever decide? Should it be 5%, 8%, or some other number? Whatever, the proposed target, we could always have 25 bps more per year. But then why be stingy? We can have growth of 100% per year, right?

Maybe we should consider that price and quantity controls really don't work in monetary policy any better than they work in bread, shoes, rents and wages.

John Hall writes:

My recollection of the Austrians is that they view the natural rate of interest as the amount that would balance supply and demand for money (or maybe investment) in the evenly rotating economy (which is basically an equilibrium concept). So I don't think that they are really that far from where you are. The argument about the government is that they would push the rate below or above the natural rate. I don't think they would argue that the government can manipulate the natural rate through monetary policy (or if they can, that it is a large effect).

Maurizio writes:

A question from a layman which might only be loosely related.

Robinson Crusoe has to give up some consumption today in order be able to consume more tomorrow. It seems there is a kind of law of nature: in order to consume more tomorrow, you must consume less today. That's be because you need to save something to keep you alive while you are building the capital that will allow you to consume more tomorrow.

So the "natural rate of interest" in a society is just a measure of how much giving up consumption today will allow you to consume more tomorrow. If the natural interest rate is high, this means that if you give up consumption today, you will be able to consume a lot more tomorrow.

Now, when I hear economists such as Scott Sumner say that "today the natural rate of interest is zero (or below zero)", what I understand is "today the economy is such that giving up consumption today does NOT allow you to consume more tomorrow".

Now my instinctive reaction is to ask: 1) Does this even make sense? Can we even _conceive_ a world where giving up consumption today does not allow you to consume more tomorrow? How would this world look like in Crusoe's island? 2) at any rate, what CAUSED such a situation? How did we end up in a situation where giving up consumption today does not allow you to consume more tomorrow?

Roger Sweeny writes:

You don't have to agree with me, but I'd encourage Austrian readers not to make the same mistake as those dreamy-eyed environmentalists


marcus nunes writes:

Move from "estimation" to "experimentation"

Dan W. writes:

The central bank needs to stick with its original purpose of shoring up the stability of the banking industry. The expansion of responsibilities to include employment and inflation and now growth, presumes a central bank that has powers that in reality do not exist. Yet in the futile attempt to demonstrate such powers the central bank has corrupted capitalism and created a banking system that is fragile, over-regulated and under-capitalized.

George Selgin writes:

I must disagree with you, Scott, in holding the "natural rate" to be a useless concept.

First of all, it is certainly the case that the concept must be regarded as referring to the real rate of interest, and not to the nominal rate. There is indeed no such thing as a "natural" nominal rate in Wicksell's sense. As I taught as much to my undergraduates for 30 years, you must forgive me for regarding the whole part of your post that refers to the lack of a nominal natural rate as addressing a straw man.

As for the claim that Wicksell equated the natural rate with a rate that achieved stable (output) prices, that is correct, but it isn't the whole story. In fact Wicksell offered several distinct criteria for his natural rate, while assuming that they were all compatible. In fact, as many authorities have since recognized, they aren't; and the stable-price level criterion was in fact the most problematic of the three.

There is, however, a perfectly reasonable way to understand the natural rate, and one that doesn't beg the questions you and others have raised. It depends on an understanding that monetary innovations tend to influence interest rates more immediately than they influence prices. (And here it is wisest to think in terms of factor rather than output prices, as doing so avoids the problems connected with productivity innovations that may coincide with monetary ones.) In the short-run, the market for money balances may be "cleared" in part by interest rate movements--that is, rates adjust to preserve loanable-funds flow equilibrium for a given nominal demand for such funds. But long-run nominal money stock equilibrium is another matter. To take the simplest case, starting from a full-employment equilibrium, eventually factor prices will rise proportionately with M. Once they do, the nominal demand schedules for loanable funds shift out just as much as much as the supply schedules originally did, and the (real) interest rate returns to its original (natural) level, ceteris paribus. How long the difference between natural and actual rates prevails is a matter of all sorts of adjustment lags. Assume an infinite lag and you are an old-fashioned liquidity-preference Keynesian. Assume no lag at all and you are a New Classical. To be a Wicksellian you need only occupy a space in between these (noxious) extremes.

Kevin Erdmann writes:

Natural rates are not low.

Returns on real estate are about 4%, real. That’s a high rate in historical terms. We have various limitations on access to real estate equity ownership so that total owner-occupied real estate value now is about $25 trillion or so. Should be $40 trillion + either because prices should be higher or because there should be about 5 million condo units in NYC, Silicon Valley, and LA. But we have limits to real investment expansion in those cities and now we have access limitations everywhere through credit markets. Natural rates are high for these “class A” fixed income holders. If you can’t get on the home equity gravy train, then your left with treasuries. Anybody with $50 and a brokerage account can get a hold of those. And at the long end, they are paying 1% real, 3% nominal. Everyone keeps wondering about the mystery, and splitting down political lines about federal debt levels, income inequality, etc., etc. and its the one thing that everyone seems to agree on – that we need to severely restrict real estate development and ownership – that is the cause of the problem. Actual, factual natural rates at the long end are probably 2 1/2% or more. The market is just bifurcated. - See more at:

Andrew_FL writes:

Much of this "critique" applies equally well to the "natural rate hypothesis" as I've seen you refer to it, with regard to unemployment.

But Austrians do not define the Natural Rate of Interest as the rate that would be present absent government per se. Instead, the natural rate of interest, (abstracting from differing risk and term premia etc. that lead to multiple market rates of interest) is simply that which equates the real supply of voluntary savings to demand for funds for investment.

Deviations from this rate according to Rothbardians could indeed occur in libertopia, absent vigilante mobs that run anyone attempting to operate a fractional reserve bank out of town. That's wrong, but it's wrong of you to characterize that view as deviations from the natural rate "magically [going] away in an idyllic libertarian utopia." Quite the opposite, in fact.

Substantial, persistent, distortionary deviations of the "bank rate" from the natural rate of interest occur in the real world as a consequence of monetary disequilibrium created by 1. banking regulation and 2. contraction and expansion of the money supply unwarranted by any change in the demand to hold money. The former is eliminated in a true libertarian utopia by the establishment of a system of free banking. The second is minimized by the freedom of the people in a libertarian utopia to select whatever they prefer as base money, and the non-existence of any single central bank issue fiat money. If people adopt gold, 2 can still happen, but to a relatively limited degree. If this strikes you as dreamy eyed, well, the idea that a central bank pursuing a policy of steady NGDP growth does better strikes me as dreamy eyed, being charitable.

As to thinking about Say's law the way Delong does, I think it's backwards. Say's law is true in theory given the right theory and the right understanding of Say's law. The question is why it appears to be "false" in practice. More specifically the question is how to make the cartoon version of Say's law true in practice, and if doing so is even desirable (specifically, we cannot take for granted that any method which might hypothetically achieve such a goal is desirable), and under what conditions is the correct theoretical version of Say's law applicable to analysis of an actual real world economy, rather than being "true" or "false."

I must second Maurizio's puzzlement as to how (though he did not phrase it this way) it is possible that the aggregate rate of real time preference for actors in the economy can be negative.

bill writes:

@ Maurizio,

Yes, it can definitely make sense. A person choosing to defer one unit of consumption would like it when that deferral also produces a return (say that the person gets 1.05 units in the future). But it can still raise that person's utility even when deferring one unit of consumption results in the receipt of 0.98 units in the future. So total consumption in the two time periods would be slightly lower than if no saving had occurred, but the utility of that consumption could be equal or even greater than if the saving didn't occur. For instance, if I could consume 2 units today and zero next year (starve to death?) or 1 unit today and 0.98 units next year, I think the deferral of consumption in the face of a negative return would still be highly preferable.

R Richard Schweitzer writes:

That which recurs when certain relationships exist in particular circumstances.

Example: Flying at a sustained power level, dropping the bomb load “causes” the plane to rise. Really?

It might better be said to be the charges agreed between affected parties to a transaction for specific other desired considerations, such as "time" deferrals, "rent" equivalents, etc., as formed without interventions by non-participants in the transactions.

Scott Sumner writes:

James, Wouldn't it be inconvenient if the nominal value of a dollar bill, in terms of dollars, was unstable? If you went to the store and they insisted that today a dollar was only worth 93 cents? You'd have to spend a lot more time negitiating prices. It seems more efficient to fix the price of a dollar at a dollar. But then what about the real value of a dollar, how does that get determined?

I'm using the term "Austrian" loosely here, for those currently worried about the Fed pushing rates below their natural level.

Maurizio, The key is that only the risk free interest rate is negative. If you are willing to accept risk then you can still get more consumption tomorrow by foregoing consumption today.

Dan, When the Fed was created the price level was anchored by the gold standard. But perhaps that's worth a post.

George, I tend to agree with the thrust of your comment, but I still think the natural rate is rather vague. You suggest that a once and for all one time increase in the money supply is neutral in the long run. That seems plausible to me. But when wages and price have fully adjusted, there is no reason to assume that you are at the natural interest rate, as monetary policy may be either expansionary or contractionary, even if the money supply is not changing at all.

I simply don't think that talking about natural interest rates is useful. The only way to tell if interest rates are too high or too low is by looking at NGDP growth. In which case why not just look at NGDP growth and ignore interest rates?

I also don't understand the "straw man" claim. I was quoting Tyler, and then I immediately pointed out that the issue he raised could be addressed by switching to a real interest rate, rather than a nominal interest rate. So doesn't that address your complaint?

Kevin, I agree, but in this post I was focusing on short-term, risk-free rates of return, which are quite low.

Andrew, You said:

"Instead, the natural rate of interest, (abstracting from differing risk and term premia etc. that lead to multiple market rates of interest) is simply that which equates the real supply of voluntary savings to demand for funds for investment."

That's precisely my problem with this view. I claim that the interest rate always equates S and I, regardless of whether it is at the natural rate or not. I also question whether the term "voluntary saving" is a useful concept.

Later you use the phrase "demand to hold money" I wonder if you realize how ambiguous that concept is, and how much is being swept under the rug when using that concept. If you mean "demand for real purchasing power", then you are back in Wicksell's world, where stable prices imply interest rates are equal to the natural rate. But I don't find that definition of money demand to be very useful.

And finally, there is nothing at all odd about the risk free rate of time preferance being negative, at the margin.

Andrew_FL writes:

@Scott Sumner-That's the thing, the intended level of voluntary saving by individuals does not equal S.

I guess we differ in whether we find the former or the latter a more "useful" concept.

I don't, incidentally, mean "demand for real purchasing power" per se, or at least, I definitely don't intend to define demand to hold money in such a way as to imply the natural rate is that which stabilizes some set of prices.

To your last point, you say it's not odd, well, okay, assume I'm just obtuse. How does that situation arise, exactly? What exactly is your operating theory of the function of interest rates?

Kevin Erdmann writes:

I don't see the distinction. The entire yield curve has shifted down.

Incidentally, I have toyed with the idea that our typical construction of yields is backwards. I find that real expected returns on corporate assets are surprisingly stable cyclically and secularly - around 7%-8% total annual returns. Considering the typical duration of assets and debts looks like it is somewhere around the duration of 10 year treasuries, long duration yields are the most important yields, and I think it makes things much more intuitively coherent to start at that corporate return on assets, then deduct a yield discount from that for avoiding cash flow risks to get to the long term treasury yield, then subtract a yield from that for avoiding duration risk to get to short term yields.

The fact that we do it the other way leads to broad misunderstandings, like the myth that low short term rates are associated with corporate leverage and reckless investment, when really the low short term rate is usually associated with risk aversion and consolidation.

Considering the lack of real estate options, savings must either go into more risky equities or into treasuries, and I don't see any reason why that wouldn't trickle down to short duration securities. The deviation from long term trends at the outset of the crisis is pretty stark.

ThomasH writes:

My only quibble is with a side piece of rhetoric. The issue of global climate change is not finding or returning to any "natural" percentage of CO2 (and other "greenhouse gasses") but in finding the least cost way of reducing the harm from climate change, which is going to be really difficult to estimate and those estimates and estimates of what the least cost policies will be are going to be up for discussion from now until approximately forever. Given where we are, the path of equilibrium percentages is unlikely to contain any that we humans have ever lived in.

ThomasH writes:

@ Erdman

To paraphrase Faulkner, (1)

"Natural rates are not low." They are not even natural.

Whatever "natural"might mean there ought to be at least one "natural" rate for every policy set unless one also thinks that only one policy set is "natural."


James writes:


The real value of everything, including dollars, is determined by supply and demand. You already know this. Nothing in your reply to me addresses the problems associated with price and quantity controls.

Michael Byrnes writes:


Would you accuse Apple of price and quality controls because they decide, in a top-down manner, how many iPads to produce and what to charge for them?

Maurizio writes:


For instance, if I could consume 2 units today and zero next year (starve to death?) or 1 unit today and 0.98 units next year, I think the deferral of consumption in the face of a negative return would still be highly preferable.

of course, but this begs the question. Why are those your only options? why aren't your options to either consume 2 units today or 1 today and 1.5 tomorrow?

In Crusoe's world, what kind of situation would cause him to have as his only options to either consume 2 today or 1 today and 0.95 tomorrow? why can't he build capital to increase his productivity tomorrow?

bill writes:

@Kevin Erdmann,
I like the implications of your approach (starting with longer term corporates and subtracting).

I work in commercial real estate finance. And spreads have been greater for the last 6-7 years than at any time during previous crunches, even those prior peaks. Something about our macro situation and monetary policy is still keeping interest rates to real users of capital (non US Gov't) moderately high. I'm not complaining about paying 4.5% or 5%, but that's not zero either. I believe that "something" is the fact that the Fed appears rudderless.

Scott Sumner writes:

Andrew, It's not clear to me how you define demand for money. Can you be more precise? How would we measure it?

And the role of interest rates is to equate desired saving and desired investment. There is no reason it has to be positive.

Kevin, I'm not sure I understand your first long paragraph, but I agree with the next two paragraphs.

Thomas, Doesn't that support my claim that "natural" is not a useful concept for climate change?

James, You said:

"The real value of everything, including dollars, is determined by supply and demand. You already know this."

No I don't already know that. The value of goods traded in perfectly competitive markets is determined by supply and demand, but not goods traded in monopolistic comp., oligopoly, and monopolistic markets, which is a majority of markets.

Michael Byrnes writes:

Maurizio wrote:

"In Crusoe's world, what kind of situation would cause him to have as his only options to either consume 2 today or 1 today and 0.95 tomorrow? why can't he build capital to increase his productivity tomorrow?"

Let's say that part of Crusoe's work involves harvesting native fruits and vegetables, ie things that have a shelf-life. He'll need to find ways to preserve what he can't eat right away (otherwise he faces a total loss), but maybe even his most effective methods of preservation (drying, fermentation, ???) produce a product that is not quite as valuable to him as the freshly picked produce.

Andrew_FL writes:

I would not ordinarily attempt to define it in a way which would make measuring it easier, rather than harder, but:

Roughly speaking, as the ratio of the nominal value of all transactions involving the exchange of scarce physical goods/services, whether final or not, carried out using a particular money unit, to a broad index of the amount of money units, in a broadly defined sense (to include money substitutes), extant, appropriately weighted according to their...I had a different word in mind than "moneyness," I think it was "currency" in the sense of a property a thing can have, rather than in the since of a thing only a certain class of thing is. That would be the closest I can think to a way of actually "measuring" the demand to hold money.

That being said, others have written much better about this than I have so it's easier to tell you whose definitions I would endorse on this than to articulate it myself. The best Austrian writing on the topic of the demand to hold money I know of is "A subjectivist approach to the demand for money." by Steve Horwitz.

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