This paper's interesting!
Well, I have to say I've been stumbling thru a lot of PDFs lately with John C. Williams's name on them, and Thomas Laubach's, and related papers on the natural rate of interest, on the decline of the natural rate, and on the cause of the decline. Given that context, this paper is mighty interesting.
Full disclosure: I'm only two pages into it. But take a look at the abstract:
I extend the model of Laubach and Williams (2003) by introducing an explicit role for the financial cycle in the joint estimation of the natural rates of interest, unemployment and output, and the sustainable growth rate of the US economy. By incorporating the financial cycle – arguably an omitted variable from the system – the model is able to deliver more plausible estimates of business cycle dynamics. The sustained decline in the natural rate of interest in recent decades is confirmed, but I estimate that strong and persistent headwinds due to financial deleveraging have lowered temporarily the natural rate on average by around 1 p.p. below its long-run trend over 2008-14. This may have impaired the effectiveness of interest rate cuts to stimulate the economy and lift inflation back to target in the immediate aftermath of the GFC.From what I've seen, Laubach and Williams (2003) is the starting point for a lot of what's happened since, regarding the study of the natural rate of interest or "R-star". Krustev's paper takes their model and to it adds "an explicit role for the financial cycle". The paper makes finance a more central part of what's been happening in our economy, and what's been happening to it. And that's a good thing.
Krustev's change to the Laubach and Williams model gives rise to "more plausible estimates of business cycle dynamics." In addition, the modified model confirms the sustained decline found by other models. These features are more of an advertisement for this paper than anything else. But it's a good advertisement.
The real kicker comes at the end of the abstract:
I estimate that strong and persistent headwinds due to financial deleveraging have lowered temporarily the natural rate on average by around 1 [percentage point] below its long-run trend over 2008-14. This may have impaired the effectiveness of interest rate cuts to stimulate the economy and lift inflation back to target in the immediate aftermath of the GFC.That's interesting.
The effect of the deleveraging, pushing the natural rate down, is obvious now it has been pointed out. And, given that effect, we should have expected to find "the effectiveness of interest rate cuts" impaired. This explains both the decade of slow growth that followed the GFC, and the trouble the Fed had to bring inflation up to its two-percent target.
The one-paragraph abstract is followed by a one-page "non-technical summary". The summary expands on what we've seen in the abstract. There is another advertisement for Krustev's paper. He points out an apparent flaw in the Laubach and Williams model, which is rectified by extending the model to include the financial cycle:
... updated estimates of output gaps from the LW model since the Global Financial Crisis (GFC) have shown substantial deviation from results derived on the basis of production-function approaches; consequently, their plausibility has been questioned ...This kind of advertising I could read all day.
In addition, the summary points out again that
strong and persistent headwinds due to financial deleveraging have lowered the natural rate of interest on average by around 1 p.p. below its long-run trend over 2008-14. This might have impaired the effectiveness of interest rate cuts to stimulate the economy and lift inflation back to target immediately after the GFC.But the deleveraging worked itself out. People apparently began to feel that they had deleveraged enough. The focus on deleveraging gave way to other things. Krustev's story includes this change:
The dissipation of these headwinds implies that monetary policy should have regained traction since 2015 as the natural rate of interest rebounded, aligning itself to its long-run component.I can only imagine that less deleveraging means less downward pressure on the natural rate, so that the rate may have been tending to rise since 2015. I guess that's what "regained traction" means. I'm looking for as much as a "1 p.p." increase in the natural rate since that time. And again I have to say: That's interesting.
By way of comparison, let me share part of what I hoped would become part of a long blog post about my thoughts on the natural rate of interest:
In 2015, in Measuring the Natural Rate of Interest Redux, Thomas Laubach and John C. Williams observed that:John C. Williams has held for some time that the decline in the natural rate of interest is "permanent" and that there are no indications of any rise in the rate. This has been bothering me for a while now, because when I look at the Laubach and Williams data I see a definite bottom around 2013 (blue) or now (red) and a very likely increase thereafter:
Persistently low real interest rates have prompted the question whether low interest rates are here to stay.Their answer? Here to stay, yes:
Since the start of the Great Recession, the estimated natural rate of interest fell sharply and shows no sign of recovering.Shows no sign of recovering.
In 2016, in Measuring the Natural Rate of Interest: International Trends and Determinants, Holston, Laubach and Williams pointed out that
Sustained extraordinarily low interest rates in most advanced economies since the global financial crisis have heightened interest in the question of whether the natural rate of interest has permanently declined and why.On the question of a permanent decline, they answer:
We find no evidence that the natural rates are moving back up recently.More recently, in May of 2018, in The Future Fortunes of R-star: Are They Really Rising?, Williams wrote
Recently some economists and central bankers have pointed to signs that the fortunes of r-star are set to rise. I wish I could join in this optimism, but I don’t yet see convincing evidence of such a shift. The longer-run drivers still point to a “new normal” of a low r-star and relatively low interest rates.And by the way, Williams is talking about where interest rates will be, "not just over the next few months, but over the next several years".
Low, for the next several years.
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| Graph #1: The Natural Rate of Interest, from Laubach & Williams Data |
This paper is interesting. I gotta go read more now.
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