Articles on the Natural Rate of Interest and the Relationship Between Central Banking and the New Nationalisms

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Well, I’m still slaving away on the book. I hope regular readers will appreciate the fall-off in posts in this regard. The book will be worth it. I promise.

Anyway, the ever present drip of my publications elsewhere should prove to be at least somewhat satisfactory. I have two pieces in the latest issue of the Journal of Regulation and Risk North Asia. The journal features pretty big names from time to time — Elizabeth Warren is in the current issue and the likes of Adair Turner, Andy Haldane and my favourite economist Paul Krugman have appeared in previous issues — what’s more the journal gets circulation around the major central banks of the world.

So, the two pieces that I wrote are finely tuned to target that audience. The first short piece (on pages 59-63) is an argument against the existence of a natural rate of interest. This is a fetish that central banks need to give up ASAP. The second longer piece (on pages 195-206), co-written with my friend and colleague Thomas Dwyer, is about the challenges facing central banks in light of the recent upsurge in nationalist sentiment across the world. This article is particularly pertinent to recent developments in the Eurozone as well as in Scotland and ties into the debates around austerity and expansionist policies. There is actually very little written on this important issue as of yet. But if it gets any attention our article might go some way in starting that very important debate.

Here is the link to the Journal which has been made freely available online:

Journal of Regulation & Risk – North Asia, Volume VI, Issue 1, Spring 2014

About pilkingtonphil

Philip Pilkington is a London-based economist and member of the Political Economy Research Group (PERG) at Kingston University. You can follow him on Twitter at @pilkingtonphil.
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40 Responses to Articles on the Natural Rate of Interest and the Relationship Between Central Banking and the New Nationalisms

  1. Chris Rogers says:

    Philip,

    Many thanks for your post and articles provided for the Journal – you are indeed correct, the Journal has a good working relationship with many renowned central bankers, supervisors, academics and economists. That said, we don’t hold back our fire and are keen to expand our coverage and those we cooperate with.
    Regards
    Chris Rogers

  2. Kris says:

    The articles seem to have been deleted ~

    • Don’t think so. I can see them fine… Here:

      • Kris says:

        Thanks – I can access them from this link. The link in the email version leads to a deletion notice for some reason.

  3. ivansml says:

    Re: natural rate of interest

    If we define natural rate as overnight interest rate consistent with zero inflation (as you do in your article), what exactly does it mean that natural rate does not exist? That no matter what central bank does, the inflation will do its own thing? That’s what you seem to be saying – that other interest rates and rates of return (and thus economy as a whole) are disconnected from short-term rate set by central bank due to animal spirits or whatever.

    This is pretty strong claim, essentially stating that money is neutral and monetary policy (as currently practiced) has no real effects. The evidence: single observation, where overnight rate went up but mortgage rates stayed the same. Wow. Hold the presses, economics has been disproved!

    Instead of pointing to mountains of existing literature that estimate (nonzero) effects of monetary policy, let’s just look at the same relationship over longer period:

    http://research.stlouisfed.org/fred2/graph/?g=CXi

    When Fed funds rate goes up, mortgage rate tends to go up too, and vice versa. Looks like animal spirits are not so unpredictable after all.

    • I hope you don’t provide this sort of citation in your academic articles, ivansml. First of all this is not the implication:

      This is pretty strong claim, essentially stating that money is neutral and monetary policy (as currently practiced) has no real effects.

      That is what we call a “strawman” argument. Usually set up by ignorant, rowdy people on the net. I actually wrote:

      This is because these rates are only partly influenced by the overnight interest rate. (p59)

      In the article I gave a specific example. Look:

      In mid-2004, when the overnight rate was set at one per cent, the 30-year con- ventional mortgage rate was around six per cent, while in mid-2006, when the overnight rate was over five per cent the mortgage rate remained at around six per cent. This reflected, as we now know, innovations in the market for mortgage securities, most notably, the now notorious Mortgage- Backed Securities (MBS). These low interest rates were part of the reason for the housing bubble that led to the financial crisis in 2008. (p60)

      Now, let’s just fix up that graph a bit so that we can see if this is true… ooops… there we go… that was easy…

      http://research.stlouisfed.org/fred2/graph/fredgraph.png?g=CXA

      Read closely. Think. Respond. Not hard. Try not to jump to conclusions about what you think to be the implications of my argument. (And consider that if I got the data for the two interest rates you link to I just *might* have noticed the gravitational pull. Because if you assume the other guy is a total fucking idiot its often you that come off looking like the fucking idiot).

      • ivansml says:

        Well, Phil, it’s not that hard. Either the central bank can influence the rest of the economy by setting short-term interest rate, or it can’t (the latter situation might be described as money neutrality, but OK, it’s a loaded term so let’s not dwell on it). Your argument implies that it can’t.

        If that’s not what you meant, perhaps you should work on your writing skills. And if it is what you meant, you should take responsibility for and defend your claims (or admit you made a mistake).

        I didn’t say your example was not true, I suggested it’s not representative of general pattern that we see in the data. Data that anyone can check in 2 minutes on FRED website. If you haven’t bothered to do even that, I wonder why anyone should take your article seriously.

      • ivansml writes:

        Either the central bank can influence the rest of the economy by setting short-term interest rate, or it can’t… Your argument implies that it can’t.

        But the article clearly states:

        This is because these rates are only partly influenced by the overnight interest rate. (p59 — My Emphasis)

        Conlusion:

        ivansml, despite thinking himself a scholar is actually an internet brawler with poor citation skills.

        Seriously, dude, you’re getting more like that troll Pontus by the day. I used to think that you could string together a coherent argument. I’m losing faith.

      • ivansml says:

        Ah, I see you hedged your bets. Of course then your argument loses any force altogether, since standard theory also predicts that other interest rates will respond only partially to overnight rate. A 30-year mortgage rate is an average of zero-coupon rates over its lifetime, each of which will depend on expected future path of short-term rates, risk premia and credit risk. That this other stuff may vary independently of central bank policy proves nothing.

        Also I wonder where did “partially” drop when you later wrote:

        “The fact of the matter is that central banks have no control over what we might refer to as the money rate of interest.”

      • Again. Poor citation. You have to be careful with that. Especially after doing it twice. You should be extra careful. Try the full quote.

        The fact of the matter is that central banks have no control over what we might refer to as the money rate of interest. If we take this money rate to encompass all the lending rates in the economy… (p60.

        I.e. they don’t have CONTROL over the money rate — in contrast to the overnight rate — if we define the money rate as all actual existing money rates. I am here following through the previous argument which you either didn’t understand or willfully misunderstood. What I am trying to show is that there are other forces operating on the “money rate of interest” and therefore the central bank does not directly CONTROL it.

        As far as mainstream theory recognising the partial effect. I’m sure they do. It’s immediately and stunningly obvious. But they don’t integrate this coherently into the theoretical edifice (Taylor rule, natural rate, etc.). Sorry but they don’t. And other economists I talk to see this very quickly.

        You don’t see it because you don’t want to admit I might be right because you’d lose face. That much is obvious from your burning desire to misunderstand what I was saying. Step back. Take a deep breath and ask yourself “Do I have a personal dog in this fight?” If you find that you do step out of the ring because you’re just another internet warrior and I have no time for that.

      • ivansml says:

        Wow. So you have “proven” that since other interest rates depend also on other things in addition to overnight rate, central bank has no “direct control” over them. As if anyone ever claimed otherwise. What an insight!

        Too bad you wasted several pages of your article on this triviality instead of actually discussing why “they [mainstream] don’t integrate this coherently into the theoretical edifice (Taylor rule, natural rate, etc.).”

      • I did discuss that. You look like a real mug on this one, bud. A real stubborn mug.😉

    • Also might be worth a look:

      In this paper we consider to what degree the decline in spreads in 2009 can be attributed to the purchases of mortgage-backed securities by the Federal Reserve and the Treasury. This question is very important for deciding whether or not to use such programs in the future as a tool of monetary policy.

      http://www.ijcb.org/journal/ijcb12q2a1.pdf

      Because I think the Fed might be on board with me on this one; just as a certain prominent economists in the BoE was very sympathetic to what I was saying when I spoke with him a few weeks ago. I would imagine most of the profession would be sympathetic too. Practically speaking I think they would agree. It does do awful damage to a lot of what they’ve been saying about the Taylor Rule and so forth though.

    • Tetraico says:

      “This is because these rates are only partly influenced by the overnight interest rate”

      “The fact of the matter is that central banks have no control over what we might refer to as the money rate of interest. If we take this money rate to encompass all the lending rates in the economy”

      Of course the overnight rate is not the only determinant of all other interest rates and as far as I know nobody would claim such nonsense. No need to become rude though, who has never thought that he has discovered something new and in the end it turned out to be old, common knowledge (well, good editors usually inform you about this before publication).

      • There is some serious lack of basic reading comprehension going on in this comments section. In my response to ivansml heroic misreadings of the article I wrote:

        As far as mainstream theory recognising the partial effect. I’m sure they do. It’s immediately and stunningly obvious. But they don’t integrate this coherently into the theoretical edifice (Taylor rule, natural rate, etc.). Sorry but they don’t. And other economists I talk to see this very quickly.

        Now I get a response from someone else saying:

        Of course the overnight rate is not the only determinant of all other interest rates and as far as I know nobody would claim such nonsense.

        I am beginning to think that there are some people reading this blog who simply cannot digest any type of new argument. Predictable. This is the nature of the mainstream. The default stance is that they know everything already and that they’ve integrated it into their theoretical frameworks; the truth is that they know very little and they have integrated almost nothing into their frameworks.

      • ivansml says:

        @Phil: “There is some serious lack of basic reading comprehension going on in this comments section.”

        Geez, I wonder why.

        In my heroic “misreading” of your article, I in fact tried to work out charitable interpretation. In this case, such interpretation would be that overnight rate has no (or only very limited) impact on the rest of the economy, so that the whole concept of natural rate would be moot. This is not really true, but one could at least imagine a coherent argument why it might be so (segmented markets? very low intertemporal elasticity of substitution?). It really didn’t cross my mind that your whole point is about the trivial fact that central bank cannot control every type of interest rate directly.

        However much you dislike it, we already know this and it’s perfectly compatible with mainstream theory, so merely restating this obvious fact as an evidence of errors is non-sequitur. If you insist that “they don’t integrate this coherently into the theoretical edifice”, feel free to point out where exactly you discuss this and what exactly is the incoherence about. It’s certainly nowhere to be found in your article.

      • @ivansml

        My intuition is that economists who do not understand the argument when they hear it do not have a clear picture in their own head of what the “natural rate” is or how it functions. This, in turn, I suspect is due to unfamiliarity with source literature and a tendency to take any argument cloaked in algebra on authority.

        So, let’s play it this way. Why don’t you lay out as clearly as you can (i) a firm definition of the natural rate or interest and (ii) a clear exposition (not too long please!) of how it theoretically functions to achieve its results.

      • ivansml says:

        Ah, I see instead of offering response you’ve resorted to the “unfamiliarity with source literature” argument, a.k.a. “I’ve read all these old books and you haven’t, so shut up”.

        Anyway, let’s play. Natural rate is a purely theoretical concept. As such, it’s precise definition is not set in stone, depending on what Wicksell or whoever else wrote long time ago, but it can be whatever we it define it to be, based on the underlying theoretical model, as long as it captures the same general idea. It’s not surprising different people use slightly different definitions (Wicksell himself proposed several). This one from Laubach & Williams (2003) [1] is quite reasonable and probably close to how the concept is usually understood by central banks:

        “it is useful to define the natural rate of interest to be the real short-term interest rate consistent with output converging to potential, where potential is the level of output consistent with stable inflation. In this formulation, the natural rate of interest, hereafter referred to r*, represents a medium-run real rate “anchor” for monetary policy and corresponds to the intercept term in feedback rules such as Taylor’s(1993) Rule.”

        And what is it good for?

        “Time variation in r* and in particular its real-time mismeasurement is potentially important for the conduct and performance of monetary policy. [… We] come to the conclusion that there are relatively large stabilization losses associated with r* mismeasurement, and that these losses can be mitigated by timely updating of r* estimates.”

        In other words, if central bank wants to stabilize inflation and output, it should modify intercept term in its policy rule when r* changes, e.g. due to structural changes in long-term growth rate.

        Other people use different definitions. For example, Woodford and many New-Keynesian models define natural rate as real interest rate (possibly different in each period) that would prevail in version of the model with no frictions and flexible prices. Under some conditions, setting nominal rate equal to natural rate in each period would eliminate inflation and also be optimal stabilizing policy. In more realistic version of the model, CB faces nontrivial tradeoff between stabilizing inflation and output, and natural rate rule may no longer be optimal, so it’s really more of an internal theoretical “benchmark” than actual operational rule. Again, different theories imply different definitions and interpretations.

        [1] http://ideas.repec.org/a/tpr/restat/v85y2003i4p1063-1070.html

      • Ooops. You didn’t lay out a conception of how you conceive it to work. Try again.

      • ivansml says:

        “Ooops. You didn’t lay out a conception of how you conceive it to work. Try again.”

        Which part of “should modify intercept term in its policy rule” didn’t you understand? A numeric example: if natural rate is 3% and inflation target is 2%, central bank should use 5% as average benchmark for its policy rate (setting it higher for restrictive monetary policy, lower for expansionary). If natural rate is 1%, benchmark nominal rate is 3%. If it doesn’t set benchmark correctly, it won’t hit its (long-term average) inflation target.

        Natural rate is just a number, so it doesn’t do anything by itself. If you’re asking me to lay out the whole monetary transmission mechanism… nice try, but no, I’ve got also other stuff to do. As somebody who publishes in a journal “with circulation around the major central banks” alongside some “pretty big names”, you should be already familiar with it.

        Looking forward to finally hear why “they [mainstream] don’t integrate this coherently into the theoretical edifice”.

      • Have you ever spoken to someone before who thinks they are engaging in the conversation but are actually talking about a triviality or a tangent that is not, in fact, relevant to the topic being discussed? Well, that’s where we’re at here. I understand what you’re saying. But all it shows me is that you’re simply not grounded well enough in the issues under consideration to actually engage in a meaningful discussion. I’m afraid you’re not the audience the above piece was written for. Best to end this here. Feel free to continue talking into a groundless statistical vacuum while the rest of us discuss economic theory.

      • ivansml says:

        More insults, yay! And no answer? How typical. If you don’t want to argue with commenters on your blog, just say so. There’s no need go through these ego-saving maneuvers, where you pretend to want a dialogue and then dismiss your opponent as not worthy. Really, anyone can see right through such BS.

        In the meantime, feel free to continue living in the illusion that what you’re discussing has anything to do with economic theory🙂

      • I think you might want to go and read up on the supposed mechanisms through which the natural rate is supposed to work. Otherwise I don’t think you’ll have much to give or take from this discussion and you’ll be better suited to discussing derivative central bank estimates without considering the concepts they are based on — you’re rather eloquent at this and I congratulate you on this achievement.

        I know that you’ll seal yourself into your own little bubble of discourse and render the theoretical issues hiding behind your concepts (potential GDP etc.) null and void in order to fend off knowledge of the issues you discuss and replace it instead with empty and hollow catchphrases and unexplained ideas that you don’t actually grasp (in Soviet Russia they used pseudo-Marxist terminology for this officialistic babble; in central banks today the lower-ranks utilise pseudo-marginalist babble). The best way to do this is to pretend to assert that you are doing science while others are doing something far less Holy. But it is a clownshow.

        If that’s your path, so be it. I tip my hat to you, sir. But don’t engage with real discussions. Just avoid them. You’ve made a right show of yourself on here over the past two days. And, frankly, I’ve lost a lot of confidence in what I supposed you to be; which was a relatively able defender of the mainstream.

      • ivansml says:

        Even more insults. You’re on fire tonight, Phil!

        I’m all for serious discussion about limits of theoretical concepts such as natural rate or potential GDP. The problem is you have NOT provided any such serious criticisms. You’re obviously unable to articulate your position and respond to elementary objections. Instead you reply with ad hominem and evasive shifting of discussion.

        Also, this passive-agressive tone of yours (“I’m afraid you’re not the audience the above piece was written for.”) is really becoming silly. Because let’s not pretend this is some arcane piece of deep theory we’re discussing here – it’s a short commentary published in non-peer-reviewed journal, based (at least the part about natural rate) on a previous blogpost, originally posted at Naked Capitalism if I recall correctly. If you’re unable to write even a few blog-worthy paragraphs in a way that would convey your argument clearly, without constant backpedaling and goalpost-moving, then maybe the problem is with you, not me.

      • I have obviously been too verbose and have not stated my position clearly enough: you have given me no evidence that you understand the actual theory that the natural rate of interest is based on. You have provided me with evidence that you can superficially discuss central bank-style papers that use the term “natural rate” without defining how it functions (in mainstream stupidspeak: you use a technical term without providing a model of how it functions). But I find this uninteresting because I think it to be the sort of second-hand idea that third-rate economists discuss. I’m not interested (hence my archaic tendency to read silly ‘old books’). This blog does not deal with derivative ideas.

        If you want to discuss an idea you must understand the idea and the theory/model that it is based on. Otherwise you are just taking other theorists/modellers at their word and using their terms uncritically. That is the hallmark of a third-rate thinker.

      • Tetraico says:

        “I am beginning to think that there are some people reading this blog who simply cannot digest any type of new argument. Predictable. This is the nature of the mainstream. The default stance is that they know everything already and that they’ve integrated it into their theoretical frameworks; the truth is that they know very little and they have integrated almost nothing into their frameworks.”

        I am a Post Keynesian (why else would I be here) so you might want to stop assuming that every criticism is coming from “the other camp”.
        Of course monetary policy should not be used as the only stabilization tool, not just when we are the ZLB but also in general (here I disagree with the Woodfordians). But I don’t think Koo or you are on the right track when you totally dismiss monetary policy and certainly not when you do it via trivialities like pointing out obvious things like the fact that the CB can normally (QE influenced long rates) only influence short rates. You can argue forcefully for the usefulness of fiscal policy as a stabilization tool without spouting out Austrian nonsense about the ineffectiveness of monetary policy (I know that you don’t like being compared with Austrians but this is what your argument boils down too when you imply that monetary policy is ineffective).

      • Tetraico says:

        About the natural rate of interest, it is obviously the short run rate of interest at which there is no cyclical unemployment. No idea why you ask questions about such totally basic stuff, especially as the natural rate of interest is the most powerful argument for fiscal policy: right now it is negative so monetary policy has no traction, the public has to massively invest (preferably in green energy if we wanna achieve two goals with one instrument) in order to get us out of the underemployment equilibrium.

      • (1) Nowhere did I point out the “ineffectiveness of monetary policy”. Please provide a quote substantiating this claim. Thank you.

        (2) I had an opportunity to write a short op-ed in which I could try to discredit the natural rate for an audience of central bankers. Obviously I did not get into the underlying theoretical argument (which I believe is new, or at least comes at it from a new angle). I did not, however, merely state that the CB can only target short-term interest rates. Again, if that is what you took from the article then you did not understand it and I cannot help you.

        (3) That final comment shows me beyond a shadow of a doubt that, no matter what you label yourself, you are not a Post-Keynesian. No Post-Keynesian would accept the argument for a natural rate. There are at least two or three well-known theoretical criticisms of the concept in the Post-Keynesian literature.

      • Tetraico says:

        “No Post-Keynesian would accept the argument for a natural rate.”

        Yeah and only Austrians would deny that monetary policy has effect upon ouput. Because whether you like it or not, this is what Wicksellian natural rate of interest denial boils down to … and I might add that it is on a similar intellectual level as Chicago school demand denial.

      • Crude stuff. Now I know you’re not a Post-Keynesian. You wouldn’t make the grade, cadet.

    • Tetraico says:

      I really like how you constantly show that you are more concerned about tribal identity and dogmatism (plus some youthful, thoughtless authoritarianism) than good economics.

  4. pontus says:

    Allow me to make a rather radical statement: If there are n comments in this blog, and the nth comment is not written by Phil, there will be n+1 comments with probability 1.

    • Otherwise translated: the blog owner responds to most comments on the blog. Thanks for the input. Always nice to see the best and brightest of the mainstream have such capacity for debate.

      • Pontus says:

        QED

      • Er ma gerd! I can’t not believe I walked into that trap! Geezum Pontus, you sure are one wily trickster!

        Cambridge’s finest, folks, Cambridge’s finest. To the untrained eye they act like teenagers. To the trained eye: misunderstood geniuses.

  5. Be A Debaser says:

    When’s the book out?
    Where can we (well maybe just me, don’t think ivansml will be coughing up) buy it?

    • Haha! I have no idea. I still have to find a publisher (I haven’t looked that hard yet…). I’d say that the manuscript will be finished in a week or two. So, hopefully soon. There will be gratuitous advertisement on this blog and maybe a review copy for ivansml and Pontus. So, no worries there!

  6. GermanAngst says:

    Only an argument if you take uncertainty seriously. The natural rate should be at leasts set to equal the cost of running a monetary system. In a commodity environment for example it is the cost of minting, but in todays situation it is the cost of bailing-out banks?!

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