Scott Sumner  

A note on the "natural" rate of interest

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The term 'natural' has multiple meanings and even more connotations. It often means something like free from human interference, and sometimes comes with a connotation of better or healthier.

When economists refer to a "natural rate of interest", however, those definitions don't work. Obviously no interest rate can be free of human interference. It might mean something like "free of government interference", but economists have given the term an entirely different meaning.

Economists define the natural rate of interest as the interest rate that is expected to deliver a level of aggregate demand which is conducive of macroeconomic stability. Wicksell thought of macro stability in terms of price stability, so he defined the natural rate as the interest rate likely to lead to price stability. But there are as many natural rates as there are theories of macroeconomic stability.

Thus the natural rate is not a single variable that is "out there", waiting to be discovered by humans, rather its a roundabout way of describing macro stability. In the mildly inflationary period around 1900-10, Wicksell might have said that prices were rising, or "the interest rate is below the natural rate". Those statements were essentially identical.

This post was prompted by a comment left by Cloud Yip, in a post where I suggested the natural rate of interest in Hong Kong was the US interest rate. Here's YiP:

For the HK part, I think you only mean the linked exchange rate is "perfect"in the sense that it established credibility and the monetary policy is rigid as intended right?

You don't mean that it is "perfect" in the sense that the interest rate in HK is very close to the natural rate in the region, I assume. Haven't really check it yet, but I suppose that the NGDP is quit volatile......

I think we in HK are staying very close to the natural rate of the US, and it is actually quite an interesting counter example to your main point in the article. I think the supposed deviation from the natural rate in HK (which I simply assumed without much proof) is pushing the economy overheat in here.

This is a valid criticism, for two reasons. First, I do view NGDP stability as the best criterion for judging the natural rate, not a stable exchange rate. And second, it's a stretch to view a stable exchange rate as "macroeconomic stability".

In my defense, I was trying to be a bit provocative to make a point. Just as some people view price stability as evidence of monetary stability and others look to NGDP, there are people who view a stable exchange rate as evidence of macro stability. Indeed that might well be the view of the authorities in Hong Kong. My point is that there is a natural rate of interest associated with each and every variable that one might view as the criterion for macro stability.

Some conservatives and/or libertarians might prefer a different definition of the natural rate of interest---based on the concept of a market interest rate determined completely free of government interference. I'm not entirely unsympathetic to that definition, as it's closer to the use of "natural" in other areas of life (as compared to the Wicksellian definition.) But it's also important to note that it's not the definition used by economists, so it can lead to people talking past each other.

Free market advocates might also prefer that definition because "natural" has a connotation of "good", as with "natural foods."

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However we cannot just assume that a completely laissez-faire monetary system would provide for price stability, NGDP stability, or any other plausible definition of the Wicksellian natural rate. It might, but we just don't know. (I'm skeptical, as macro stability seems like a public good to me.)

We are left with an unfortunate situation where almost everyone wants the interest rate to be at its natural level, but each person defines that term differently. Better to jettison all talk of interest rates, natural or otherwise, and speak directly to what sort of monetary policy you want to see---the Fed targeting the price level, the Fed targeting NGDP, or no Fed with free banking, etc.

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COMMENTS (5 to date)
Cloud Yip writes:

Thanks, Prof. Sumner for the thoughtful reply.

I think HK authorities should all read this post.

Personally, I would prefer we all use mainly NGDP Stability as the definition of monetary stability. It is clear and easy to understand.

Thaomas writes:

I do not like the concept of "natural" rate of interest at all because it focuses on the one outcome of a macroeconomic conjuncture that for historical reasons is too close to the principle instrument of central bank monetary policy. Moreover, it is and outcome that of itself ought not be an objective. People do care about prices and employment so it is appropriate to make these the targets of monetary policy. The short, medium or long term interest rate (like the exchange rate) that is consistent with an optimal outcome with regard to prices and employment (of all resources, not necessarily just labor) is the optimal interest rate.

Nor do I like macroeconomic "stability" as it can mean almost anything and nothing, but usually just means "more inflation than I like."

While getting the Fed to target NGDP (really target in that it would take measure to get it back on target whether the deviations are above or below) would be much better than the soft inflation rate ceiling than that it has used since 2008, it would probably be still better to have separate targets for the price level trend and employment. NGDP targeting ties the two together in a way that is not necessarily optimal.

Scott Sumner writes:

Thanks Cloud.

Thaomas, I agree that the natural rate of interest is not a useful concept. I don't like separate targets for inflation and employment, because the Fed only has one way of affecting the economy, so two targets doesn't work well.

Andrew_FL writes:

We can't simply define the Natural Rate of Interest is a question begging way-where it is simply by definition the rate which occurs absent any "government intervention."

However it also makes no sense to define it with no reference whatsoever to the loanable funds market, but instead with reference to "aggregate demand" as you do here.

Luis Pablo writes:

Professor Sumner,

Would you be so kind to expand on the idea of macro stability as a public good? Any article or paper on the topic?


Luis Pablo

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