In Search of the Natural Rate of Interest (Part II)
Feb 15, 2006
Joachim Fels (London) and Manoj Pradhan (London)
In Part I of this note, posted on this Forum yesterday, we explained the basic concept of the natural rate of interest and the model we use to estimate its level. Put simply, the natural rate is the level of the real Fed funds rate that keeps GDP at its potential and inflation stable. The difference between this natural rate (which is not observable and thus has to be estimated) and the actual policy rate is a useful measure of the central bank’s monetary policy stance.
A time-varying natural rate of interest Looking at our estimate of the natural rate for the past 43 years, the first thing to note is that the natural rate was trending down from a peak of around 3.75% in the mid 1960s to a trough of slightly above 2.0% in the early 1990s. Since then, the natural rate has hovered sideways in a range of 2% to 2.5%. Our latest point estimate for the final quarter of 2005 is smack in the middle of that range at 2.25%. The behaviour of the natural rate broadly matches the stylised facts of US economic developments over the past 40 years. The 1960s was a time of strong productivity growth, which suggests that the natural rate — a proxy for the rate of return that can be earned in the economy — should have been relatively high too. As productivity growth declined during the 1970s and 1980s, the natural rate declined. The low point for the natural rate coincides with the slow recovery from the 1990 recession, when the economy was facing severe headwinds after the S&L crisis. The rise of the natural rate during the mid-1990s matches the acceleration of productivity on the back of the IT revolution. With several adverse shocks hitting the USeconomy since the bursting of the equity bubble in 2000, the natural rate declined again, only to recover slightly more recently to the current level of 2.25%, as the impact of the adverse shocks faded. The real rate gap as a measure of the monetary policy stance Comparing the actual level of the real Fed funds rate with the natural rate provides us with a measure of the stance of monetary policy. Recall that we label the difference between the real Fed fund rate and the natural rate as the real rate gap. When the real rate gap is positive — when the Fed keeps the real Fed fund rate above the natural rate — monetary policy is restrictive. Conversely, a real Fed fund rate below the natural rate implies that monetary policy is expansionary. The inflationary 1960s and 1970s The real rate gap was negative for much of the 1960s and 1970s, suggesting that US monetary policy was broadly expansionary during those two decades, with only brief exceptions before the recessions of 1970 and 1974, when the real rate gap became positive and policy thus restrictive. In fact, inflation as measured by the core PCE deflator, accelerated during these two decades from less than 2% to close to a peak of 10% in the early 1980s, and the output gap was in positive territory for most of the period. This result is unsurprising because our model infers the level of the natural rate (and thus the real rate gap) and the output gap from the actual behaviour of GDP and inflation. The fact that inflation was accelerating for most of the 1960s and 1970s ‘tells’ our model that monetary policy must have been expansionary, in the sense that the natural rate must have been below the actual Fed funds rate. As the transmission mechanism from monetary policy to inflation in our model is the output gap, the model also produces an estimate of potential growth that keeps the output gap in positive territory for much of the period. Volcker’s battle against inflation Monetary policy switched from an inflationary mode in the 1960s and 1970s to a disinflationary stance for most of the 1980s and 1990s. The Fed fund rate was kept above the natural rate for most of the time (that is, the real rate gap was positive), inflation trended lower from the early 1980s peak, and the output gap spent much time in negative, and thus, disinflationary territory. Policy was very restrictive, especially in the early part of the 1980s, when Fed Chairman Paul Volcker waged his war on inflation by engineering a deep recession. By the time Alan Greenspan took over as Chairman in 1987, inflation had come down from close to 10% to less than 4%. The Greenspan era The real rate gap produced by our model also helps to illustrate the various phases that the Greenspan-Fed went through over the past 18 years. Paul Volcker’s bequest to Alan Greenspan was a broadly neutral policy stance, with the real rate gap close to zero in 1987. When the stock market crashed in October 1987, the Greenspan-Fed cut interest rates slightly below our measure of the natural rate. However, policy then became increasingly tight during the late 1980s in response to rising inflation, culminating in the recession of the early 1990s, which led to another round of disinflation. During and after the recession, Greenspan kept rates below the natural level for several years as the economy was facing severe headwinds from the S&L and property market crisis. However, during 1994, policy was first normalised and the Fed funds rate was raised above the natural rate (which itself also trended higher during the period) and kept there until the recession of 2001. During the recession, the natural rate fell, but the Fed cut the interest rate way below the natural rate and kept it there for a prolonged period to stave off the perceived risk of deflation. The last phase of the Greenspan-Fed — policy normalisation — started in mid 2004 and was largely completed by the end of 2005, when our measure of the real rate gap turned zero, implying that the Fed funds rate returned to its natural level. Thus, Alan Greenspan not only inherited a broadly neutral monetary policy stance from his predecessor Paul Volcker, but also passed on a broadly neutral stance to his successor Ben Bernanke. Beyond natural Our measure of the natural rate has to be taken with a large pinch of salt as it is based on a fairly simple model of the economy, and the standard errors around the estimated natural rate are quite large for these types of models. That said, taking our point estimate for the natural rate of 2.25% at face value, and adding the current rate of year-on-year PCE inflation of 1.9% suggests that the January 31 rate hike to 4.5% has pushed the actual Fed funds rate some 35 basis points above the (nominal) natural rate. Thus, as Ben Bernanke assumes his role as Chairman, the Fed’s policy stance has entered restrictive territory. Of course, raising the Fed funds rate above its natural level may be entirely appropriate if output is above potential and/or inflation is above target. Arguably, this is the case right now. Our model estimates suggest that the output gap is positive (to the tune of 1.4% of potential output), implying that output is exceeding potential. Moreover, core PCE inflation is running at 1.9%Y, which is above the mid-point of the perceived 1-2% range for this measure that Ben Bernanke and some other FOMC members have defined as their preferred range in the past. As discussed earlier, one way of gauging the appropriate level of the Fed funds is the Taylor rule. In the simplest version of the Taylor rule, the prescribed interest rate equals the sum of the natural rate plus the current inflation rate plus half of the output gap plus half of the gap between actual and desired inflation. Plugging in our measure of the current natural rate of 2.25%, the current inflation rate of 1.9%, our measure of the output gap of 1.4% and an inflation gap of 0.4% results in a prescribed policy rate of 5.05%. This is reasonably close to the Fed funds rate priced in to the Fed funds futures contracts, and close to our US economists’ 5% forecast for the Fed funds rate. In conclusion, our estimate of the natural rate suggests that Fed policy has entered restrictive territory. Another couple of rate hikes, which would be consistent with current market pricing, our US economists’ forecasts and a simple Taylor rule (modified by our measure of the natural rate), would thus tend to slow both the economy and inflation over the medium term.
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Pause in the Recovery
Feb 15, 2006
Eric Chaney (London)
The euro area GDP increased by 0.3%Q in Q4 2005, according to a flash estimate from Eurostat, slightly below the consensus (0.4%) but in line with our forecast. On a year-on-year basis, GDP growth accelerated marginally, from 1.6% to 1.7%. This comes after the domestic demand driven rebound reported in Q3 (0.6%Q) that had freed the ECB from its inhibition to initiate the normalisation of interest rates. With no breakdown available, neither on the supply nor the demand side, we can only try to guess why the euro area recovery apparently paused at the end of last year. Disappointing retail sales in Germany and France are pointing to a possible lagged impact of the oil price spike on consumer spending, not only in these regions, but in the euro area as a whole. Also, changes in depreciation rules may have temporarily held back corporate investment in Germany. Since capex was so far the main driver of the German recovery, this policy factor may have been important. Last but not least, government deficits were lower than expected (2.7% of GDP vs. 3.0% expected) last year, indicating that fiscal policies may have acted as a drag on the economy in the second half of last year, as governments struggled to balance their books. Big-3 tumbling, Spain and Netherlands roaring Germany and, on our estimates, Italy (data on 03/02) did not grow at all in Q4, while France posted a meager 0.2%Q. Spanish GDP, up 0.9%Q was in line with expectations, still driven by buoyant domestic demand, while Dutch GDP surprised on the upside at 1.0%Q, as the economy continues to recover from its 2002-2003 recession. Available GDP estimates were suggesting that the euro area growth was only 0.2%, so we may infer that Eurostat has taken a more sanguine view on the eight countries that have not yet reported GDP estimates. Allegedly, growth was still significantly above the region average in countries such as Ireland, Finland and Greece. Taking flash estimates with caution Although pointing to a slowdown, business surveys (Ifo, Insee, Isae…) did not suggest a sharp one: based on this information, our early GDP estimate was 0.4% to 0.5%. Past experience has shown that most of the time surveys are closer to reality than early GDP estimates. For that reason, we think that Q4 data might be revised upward later. The domestic demand conundrum In my view, the key factor at this stage of the recovery is domestic demand. On the one hand, European companies are giving rather encouraging feedback about their order books, which, once all countries are aggregated, are mostly originated in the euro area (exports take only 15% of the zone’s GDP). In addition, credit data are quite bullish: on a year-on-year basis, credit extended to the private sector was up 9.5% in December, driven by housing credit (11.5%) and, to a lesser extent consumer credit (7.5%) and loans to companies (9.4%). On the other hand, “hard data” from statistical institutes are not yet conclusive regarding the recovery of domestic demand. I firmly believe that domestic demand is progressively recovering, fuelled by the historically low level of real interest rates and the stabilisation of inflation expectations around 2%. However, I must admit that the jury is still out, for lack of robust statistics. Food for ECB thoughts Our survey-based instruments and country data are pointing to a re-acceleration of growth in the first months of 2006. We expect growth to reach 0.6%Q to 0.7%Q in Q1. From a monetary policy standpoint, a 25 bp rate hike on March 2nd is almost guaranteed, as it has practically been pre-announced. Looking forward, the ECB may want to have a clearer picture of the economy before pushing rates higher.
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Inching Towards a Turning Point?
Feb 15, 2006
Elga Bartsch (London)
No doubt, the flash estimate of the fourth quarter German GDP, which showed a flat reading compared to the previous three-month period, came as a disappointment to most economists, including ourselves. Factoring in already a marked slowdown from a non-annualised growth rate of 0.6%Q in 3Q, we and the consensus had been looking for 0.2%Q for the final quarter of 2005. There were no details on demand components or other underlying supply side or income data in the report. This makes it difficult to judge whether some of the weakness in late 2005 could point towards a sharper rebound in early 2006. The details of 4Q GDP will only be released this coming week and we will reserve judgement until then. The Statistics Office indicated that the 4Q weakness that brought Germany back to stagnation largely stemmed from contracting consumer spending and falling government spending. At the same time, investment spending benefited from a rise in construction investment and from a further expansion in investment in machinery and equipment. There was no explicit mention of a significant growth contribution from net foreign trade in the report. At this stage, the unexpected shortfall in 4Q GDP growth introduces a small downside risk to our full-year estimate for 2006 of 1.8%. It does not, however, change our fundamental view that Germany is likely to stage an impressive economic comeback this year (see The Comeback of 2006, December 19, 2005). On our forecasts, German GDP growth should considerably outpace its trend this year and, thanks to a smart cyclical recovery, converge to that of the euro area. On the same day, the ZEW Institute reported the results of its latest poll of business expectations among 300 or so German analysts, economists and investors. The poll, the first data point on business sentiment in the euro area for the month of February, showed a stable reading of 69.8, after 71.0 in January. Expectations thus stayed considerably above its long-term average of 35.0, pointing to above-trend growth. At the same time, ZEW’s pollsters reported that current business conditions were seen as improving further in February. At -19.5, current conditions have now reached their highest level since late 2000. For financial markets, the main interest in the ZEW primarily stems from its close correlation with the Ifo business climate, one of the most — if not the most — important business cycle indicators in the euro area, which is due out this coming week. To make best use of the co-movements between the ZEW investor survey and the Ifo business survey, which covers around 7,000 German companies in manufacturing, construction and retail and wholesale trade, we have constructed a composite ZEW Index which, like the Ifo business climate, aggregates business expectations and current business conditions into a single headline index. As you would expect, this composite index exhibits a closer correlation with the Ifo business climate than the individual ZEW components. On our calculations, this composite ZEW index increased further in February to 25.3 from 19.7 in January. At face value, this would suggest that the February Ifo business climate could climb higher too. However, in the past few months, the Ifo business climate has paced ahead of the ZEW composite index. Historically, it has taken on average about six months for such a divergence between the two indicators to vanish and for the close relationship to re-establish itself. Factoring this adjustment process into a simple quantitative model, we obtain an estimate for the upcoming Ifo business climate of 101.8. This point-estimate is slightly more optimistic than our initial forecast of 101.5. Aside from the ZEW-based estimate, there are a number of other reasons why the Ifo business climate might correct in February, after having reached a very elevated reading of 102.0 in January, only surpassed in May 2000 and in 1991 — the hey-days of German reunification (see What’s Driving the Ifo Survey? March 22, 2004). These reasons include a lower number of workdays and a continuing correction in the US ISM since October. A potential peak in the Ifo business climate could potentially be a key signal for financial markets. Morgan Stanley’s European equity strategists argue, for instance, that in the past a peak in the Ifo business expectations was typically followed by a correction in European equity markets to the tune of 5% for MSCI Europe (see Return of the Big Corrections, February 6, 2006). Similarly, we find that past peaks in the Ifo business expectations have typically coincided with a considerable flattening of the yield curve and an outright decline in ten-year Bund yields of around 50 bp in the subsequent six months. The latter would fit the short-term trading view of Morgan Stanley’s European interest rate strategists, who argue that near-term the risks might be tilting towards lower rather than higher yields (see European Interest Rate Strategist, February 13, 2006). In our view, a correction in the February Ifo business climate should not be taken as an indication that the indicator has already peaked in the current cycle. We would rather see the Ifo business climate bumping sideways around the present levels in the coming months, maybe even reaching new historical highs. As a rough rule of thumb, the Ifo Institute itself establishes that only once you have seen three subsequent declines in the headline index can you be sure that the index has turned the corner. Before that, you could just be looking at a random monthly gyration. With that in mind, all eyes on the Ifo business climate.
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