Monday, August 21, 2023

"Is The 'Natural' Rate of Interest Back to Pre-Financial Crisis Levels?"

From Calculated Risk, August 18:

CR Note: This is related to my note earlier this week: The "New Normal" Mortgage Rate Range

From housing economist Tom Lawler:

The resiliency of the US economy in the face of the “aggressive” Federal Reserve rate hikes since last March, combined with an increase in inflation-adjusted Treasury (TIPS) yields to levels not seen in almost 15 years, have led a growing number of analysts to conclude that the so-called “natural” rate of interest (often referred to as “r-star”) has increased significantly. By “significantly” I don’t just mean back to the historically low levels just prior to the pandemic, but rather to levels closer to the period right before the financial crisis of 2008 that led to the worst recession since the Great Depression.

To be sure, many other analysts and policymakers disagree with this view. For example, in May of this year the Federal Reserve Bank of New York relaunched its widely followed measure of r-star (the model generating r-star “did not work” during the pandemic), and the results suggested that r-star at the end of last year was not much different from where it was just prior to the pandemic. Moreover, the estimate of r-star from the so-called “HLW” model for the first quarter of this year was actually below pre-pandemic levels, leading NY Fed President Williams to conclude that “there is no evidence that the era of very low natural rates of interest has ended.”

On the other hand, estimates of the natural rate of interest from Lubik and Matthes (LM) of the Federal Reserve Bank of Richmond using a different/more flexible modelling approach suggest that the natural rate of interest had increased from a pre-pandemic level of about 1 ¼% at the end of 2019 to a little over 2% in the latter part of 2022 and the first quarter of 2023.

In addition, “real” interest rates as measured by “Treasury Inflation Protected” (TIP) yields have increased recently to their highest levels in about 15 years, with 5-year TIPS yielding about 2.2% and 10-year TIPS yielding almost 2%.

Moreover, the economy this year has been much stronger than most forecasters and policymakers had expected, which would also be consistent with (though by no means proof of) a “natural” rate of interest that had increased.

Back in June Goldman Sachs released a research report questioning the reliability of the low r-star estimates generated by the HLW model, and suggested that r-star (which is stated in real terms) was probably closer to 1 to 1 1/4%, implying a nominal “neutral” Fed funds rate if we have a soft landing and inflation returns to 2% of 3 to 3 ¼%.  Since that report “market-based” measures suggest a higher value of r-star....