The âvery lowâ so-called natural rate of interest isnât unique to the U.S., San Francisco Fed President John Williams said Thursday.
The natural, or neutral, rate of interest, is the level of interest rates that would keep the economy in balance, without holding down growth or sparking inflation. But while observers have lately been consumed with the question of whether the Federal Reserve will raise rates in the U.S. â and the effect that might have on the economy and markets â a new paper co-wrote by Williams suggests that low rates may be due to deep structural factors like low productivity that aren’t easily addressed by policy makers, said Thomas Simons, money market economist at Jefferies.
Williams, using a model he first helped develop in 2003, said the natural rate appears to have also declined sharply in Canada, the eurozone, and the United Kingdom. âWe find that large declines in trend GDP growth and natural rates of interest have occurred over the past 25 years in all four economies,â the paper said. .
Read: Fed decision makers wrestle with so-called natural rate
Former Treasury Secretary Lawrence Summers has argued the low natural rate is evidence of secular stagnation and or a lack of demand for capital.
Economists used to believe that this rate was in the range of 2-3%. When added to 2% inflation, that suggests benchmark interest rates would be in the 4-5% range.
In June, the Fed estimated that benchmark interest rates would be in the 3% rate, down from closer to 4% two years ago. With inflation at 2%, that suggests a neutral rate of 1%.
The Fedâs benchmark interest rate is now between 0.25% and 0.50%.
âWe agree that a low neutral rate cannot be good news in terms of what it says about the underlying health of the economy,â said Krishna Gua, vice chairman of Evercore ISI, in a research note to clients.
âBut the Fed does not get to choose the neutral rate and if the neutral rate is indeed very low â as we believe it is and the bond market has been saying for a long time â we are much better off with a central bank that operates on this basis than one that acts as if the neutral rate was higher than it actually is and as a result overdoes hiking,â Gua said.
Simons said the Fed is acting as if it believes the neutral rate is very low because it âcanât seem to convince itselfâ to raise rates even though economic data has been relatively solid.
A low natural rate is also a problem for central bankers because it means they might not have many options for warding off another downturn. Central banks tend to cut interest rates by more than 4% in a downturn to spur lending and activity, but they would hit zero if the neutral rate was only 2.5%.
âAll else equal, a lower average real interest rateâ¦implies that episodes of monetary policy being constrained at the effective zero lower bound are likely to be more frequent and longer,â Williams said in the new paper, written with Kathryn Holston and Thomas Laubach, who are now on the staff of the Fed board of governors.