The writer is an FT contributing editor
The successive shocks we’ve experienced over the past three years have had a lasting impact on the global economy. But according to John Williams, president of the New York Federal Reserve, and his co-authors Kathryn Holston and the late Thomas Laubach, the economy may not have transformed as much as we think. They find no evidence suggesting that the pandemic and Russia’s war in Ukraine have ended the era of low inflation and interest rates in the US, Canada and eurozone over the medium term. But I would pause before breathing a sigh of relief.
For over 20 years, Williams and company have been estimating the long-run neutral (or natural) rate — known to economists as r-star. This is the interest rate at which the economy is humming along at its potential, with full employment and inflation at 2 per cent. R-star is a guiding light for central banks. Interest rates above it mean the monetary policy stance is restrictive, and below it, accommodative.
Estimates of r-star show the long-run neutral rate broadly falling for the US and other advanced economies from the mid-1980s up until the pandemic. Given how volatile the data was during Covid-19, Williams et al suspended their estimates until May. When they re-ran their new, improved models, they determined r-star had barely budged despite everything.
The implication for central banks is massive. If r-star is as low as it was pre-pandemic, then we can expect inflation and rates to fall again once the dust has settled on all the successive shocks. Episodes of monetary policy where rates remain mired at the lower levels could become more frequent.
Williams is not alone in his projection. In its latest World Economic Outlook, the IMF also concludes that advanced economy interest rates will revert to pre-pandemic levels, as does Bank of Finland Governor Olli Rehn. It’s also reflected in the Federal Reserve’s median long-run fed funds rate projection, which was once again 2.5 per cent in June: 2 per cent inflation and a 0.5 per cent long-run neutral rate.
However, the problem with using r-star as a guiding light is that it is a concept, not something that can be observed. As Williams warned in his speech last month, “Estimates of the natural rate of interest, however, are very imprecise and subject to real-time measurement error.”
Furthermore, this tightening cycle hasn’t had the predicted impact on real economies. One possible explanation is that unusual things are happening because of pandemic-related scarring. The US labour market, for example, has remained strong in the face of aggressive rate hikes partly because of significant labour hoarding as companies recall the nightmare of recent recruitment. But another explanation is that r-star has in fact risen and the monetary policy stance isn’t as tight as central bankers think.
It is too early to know which explanation is right. But even if r-star hasn’t already risen, that doesn’t mean it won’t. A number of factors could influence it. According to the Laubach-Williams model, slowing potential GDP growth has been a significant driver of a lower long-run neutral rate over the past few decades. R-star also reflects the balance between saving and investment in an economy over the medium- to long-term, with a savings glut weighing on the long-run neutral rate.
There are reasons to expect waning productivity growth and the global savings glut could change in the medium- to long-term. In many parts of the developed world, people are no longer saving for retirement but are in it, and spending more than they are earning. This is particularly true following the pandemic, given many workers over 50 seem to have chosen to permanently leave the labour force.
Elsewhere, investment in green infrastructure and subsidies may not only pare global savings but could generate a wave of innovation that boosts productivity. Investment in defence should also have tech spillovers. Meanwhile artificial Intelligence and machine learning developments are likely to progress exponentially, and their impact on productivity and growth may come sooner than expected. All of this could boost potential growth and send r-star higher.
Given that r-star is driven by long-term, secular factors, it is possible that the models are right and the long-run neutral rate has barely moved over the course of just a couple of years. But it would be a mistake for central bankers to take comfort in the notion that inflation and rates will automatically go back to the low levels we saw before the pandemic. This is their challenge for the future.
Source: Economy - ft.com
