Fed officials struggle to understand why mysterious natural rate has fallen
While Federal Reserve officials debate when to next raise short-term interest rates, they also are wrestling with the question of how high to lift them in coming years.
Signs point toward the new normal being much lower than in the past, which has broad implications for when the Fed should tighten monetary policy, how quickly, and how far.
Fed officials disagree about their likely end point, in part because they are struggling to understand why another underlying interest rate—the mysterious natural rate—has fallen in recent years. And for that many are turning to the musings of Knut Wicksell, a Swedish expert on the subject who died 90 years ago.
According to the textbooks, this so-called natural rate is the inflation-adjusted rate that’s consistent with the economy operating at its full potential, expanding without overheating. Also known as the equilibrium or neutral rate, it balances savings and investment.
The natural rate can’t be observed directly; the Fed knows it has been reached only by how the economy responds. “It’s like discovering Pluto: you can only see the effect of the gravitational pull,” said Eddy Elfenbein, an investor and blogger at the site Crossing Wall Street, comparing it to the dwarf planet whose existence was inferred from the orbits of Uranus and Neptune.
This matters in part because the natural rate guides how the Fed sets its benchmark fed-funds rate, which influences other borrowing costs throughout the economy. If the Fed pushes rates too high, it could undermine investment and cause a recession. If it holds rates too low, demand could grow too quickly, producing inflation or financial bubbles.
