The Fed Backs Off from the Natural Rate

Tim Duy recently noted in Bloomberg that the Federal Reserve is no longer guided by the natural rate of interest. Let me explain a bit. With monetary policy veering off into unchartered territory, the Fed needed some new ways of measuring what they were doing. John Williams, who had been at the San Francisco Fed and is now at the New York Fed, had advocated for watching the natural rate of interest, also known as R-star.

The idea of the natural rate is that there’s some sort of perfect rate of interest that exists everywhere in the globe, and at this rate, everything comes into perfect balance. The thing about this rate is you never know what it is exactly. You can only tell by inference. If we’re above it, then X, Y and Z are suppose to happen. If we’re below, then A, B and C are suppose to happen.

Is this right? I’m not sure but I think this is one of those things where it’s probably wiser to act as is it’s true. Importantly, the natural rate is expressed as a real rate, meaning after inflation.

Williams has argued that the natural has fallen, and I suspect he’s right. However, he recently gave a speech saying there’s been an overemphasis on the natural rate. He doesn’t say that it’s bad, but now that things are back to something like normal, tracking a natural rate is far to blurry to use an effective monetary tool.

“At times r-star has actually gotten too much attention in commentary about Fed policy,” Williams said. “As we have gotten closer to the range of estimates of neutral, what appeared to be a bright point of light is really a fuzzy blur.”

Some market participants are concerned that interest rates have increase. Let’s remember that real short rates have going from -2% to 0%. If I had to guess, I’d say the natural rate is at 1%. The Fed is far from putting the breaks in the economy.