Mario Draghi Reminds Everyone that Central Banks Do Not Determine the Medium-Run Natural Interest Rate

Link to the May 2, 2016 Wall Street Journal article “ECB Chief Mario Draghi Fires Back at German Critics” by Tom Fairless

Many complaints about central bank policy seem to assume that the medium-run natural interest rate is under a central bank’s control. It isn’t. 

In “The Medium-Run Natural Interest Rate and the Short-Run Natural Interest Rate” I define the medium-run natural interest rate as follows:

  • medium-run natural interest rate: the interest rate that would prevail at the existing levels of technology and capital if all stickiness of prices and wages were suddenly swept away. That is, the natural rate of interest rate is the interest rate that would prevail in the real-business cycle model that lies behind a sticky-price, sticky-wage, or sticky-price-and-sticky-wage model.

In the standard view of monetary policy, which is the view that I take, other than keeping the long-run level of inflation low, a central bank’s principle and crucial job is to get the economy as close as possible to the medium-run equilibrium that corresponds to what an economy would do if all prices and wages were perfectly flexible. That is, a central bank’s job is to (1) keep the long-run inflation rate low and (2) do as much as possible to undo the effects of sticky prices and sticky wages on the real variables of the economy. 

By this definition of the medium-run equilibrium, the central bank no control over the real variables in the medium-run equilibrium, other than things such as real money balances in the medium-run equilibrium. And since there is only one level of aggregate demand the gets the economy to the medium-run equilibrium–that is, saying “medium-run equilibrium” already stipulates a level of aggregate demand–the role of real money balances in the medium-run natural equilibrium is quite unexciting.

Using this terminology, hardcore “Real Business Cycle Theory” posits that the economy is always in the medium-run equilibrium, because prices and wages are almost perfectly flexible. But in discussing the nature of the medium-run equilibrium, the question of whether this is true or not is actually immaterial. The medium-run equilibrium is what would happen if the Real Business Cycle Theorists were right, whether they are or not. But the medium-run equilibrium is also close to what would happen if a central bank did a truly excellent job of monetary policy–better than any existing central bank so far, but within the range of possibility.   

If output is below its medium-run equilibrium level, the medium-run natural interest rate is likely to be above the current level of the interest rate. The reason is that businesses and households don’t like to invest when the economy is in a slump. Getting out of the slump tends to raise the interest rate. As I explain in “The Medium-Run Natural Interest Rate and the Short-Run Natural Interest Rate” and “On the Great Recession,” in a slump the path to raising the interest rate up to its higher medium-run equilibrium level is–somewhat paradoxically–through a path of cutting the interest rate in order to bring output up. Once output comes up, the interest rate will come up too. So Anyone who wants a higher interest rate should want the central bank to use a sharp reduction in interest rates for a few quarters in order to bring recovery and a sustainably higher interest rate. To try to go straight to a higher interest rate will push the economy into a worse slump and require lower interest rates to get on track–quite counterproductive from the point of view of those who want higher interest rates. 

Many people don’t understand the limitations of central banks. If they want higher interest rates, they think central banks can go there directly without serious side effects. That doesn’t work. In a slump, central banks need to get to higher interest rates by the proper path of cutting interest rates until the economy recovers; then interest rates can and should be raised. Raising interest rates first is like a sugar high for savers, that will lead to a crash when interest rates then have to be cut to stave off a double-dip recession.    

Just because central banks can’t affect the medium-run natural interest rate that is where things go if they do their jobs doesn’t mean there isn’t any reason to complain about low interest rates. In particular, low medium-run natural interest rates can be a symptom of a low rate of technological progress, which is definitely something to complain about–and something to do something about, by making sure that we fund basic research at a much higher level than we currently do and by making sure we don’t let regulations crush new firms doing new things in promising new ways. 

Less obviously a good thing, increases in government debt can raise the medium-run natural interest rate. And increases in the willingness to take risks can raise the medium-run natural interest rate, which I think is a good thing as long as people are really taking those risks themselves rather than angling to be bailed out by taxpayers. 

Draghi’s Speech

On his recent Asian trip, Mario Draghi, head of the European Central Bank (ECB), defended the ECB from attacks by the powerful argument that a central bank does not control the medium-run natural rate. Here are three key passages from the Wall Street Journal article linked at the top of this post:

1. “There is a temptation to conclude that…very low rates…are the problem,” Mr. Draghi said. “But they are not the problem. They are the symptom of an underlying problem.”

The global savings glut, Mr. Draghi said, is being perpetuated by economies in Asia and in the eurozone, notably Germany. “Our largest economy, Germany, has had a [current account] surplus above 5% of GDP for almost a decade,” Mr. Draghi said. 

2. In unusually blunt criticism last month, German Finance Minister Wolfgang Schäuble called for an end to easy-money policies … suggesting [the ECB’s] low interest rates had hurt savers.

Mr. Draghi directed criticism directly back at Berlin. “Those advocating a lesser role for monetary policy or a shorter period of monetary expansion necessarily imply a larger role for fiscal policy”

3. Mr. Draghi stressed that the ECB’s policies are helping savers, and said governments, not central banks, should address the underlying economic causes of low rates. He also urged savers in Germany to boost their returns by diversifying their investments, mimicking their counterparts across the Atlantic.

“U.S. households allocate about a third of their financial assets to equities, whereas the equivalent figure for French and Italian households is about one- fifth, and for German households only one-tenth,” Mr. Draghi said.

Let me interpret these statements. 1. Mario Draghi effectively says that medium-run international capital flows affect the medium-run natural interest rate. 2. Mario Draghi effectively says that to get the medium-run equilibrium requires closing the output gap either through monetary or fiscal policy. He criticizes German fiscal policy. But the criticism of German fiscal policy is not necessary for the point. The point is just that if fiscal policy doesn’t do it, then monetary policy needs to. As I have pointed out many times, monetary policy is more reliable, simply because it is not tangled up in politics. A sensible approach is to take what fiscal policy one can get politically (after whatever advice one wants to give), then do the rest of the job with monetary policy. 3. Mario Draghi effectively reminds savers that a healthy economy tends to raise interest rates compared to a slump, then makes the interesting point that expected rates of return can be raised by taking on more risk. There is a more subtle point Mario Draghi doesn’t make: if more people raised the expected rate of return on their savings by taking on more risks, then the risk-free rate for those who don’t want to take on those risks is also likely to be higher. The worst thing for savers is if they aren’t eager to take risks and no one else is eager to take risks either. Then everyone tries (unsuccessfully, given limited supply) to crowd into the risk-free assets and lowers their rate of return (or something even worse happens if the central bank doesn’t do its job of keeping the economy as close as possible to the medium-run equilibrium).  

The bottom line is that it is crucial to understand what central banks can and can’t do. Central banks can get the economy close to the medium-run equilibrum, which entails lowering interest rates to raise them (after recovery) and raising interest rates to lower them (after reining in an overheated economy). But central banks cannot determine the interest rate that prevails once they have done their job. To repeat, central banks cannot determine the interest rate that prevails in the medium-run equilibium any more than they can keep output permanently above its medium-run equilibrium. 

As I write in “The Deep Magic of Money and the Deeper Magic of the Supply Side,” the supply side is the place to turn to raise the natural level of output that prevails in the medium-run equilibrium. But those who agree about the supply-side roots of the natural level of output need to also remember that the supply side is the place to turn to raise the natural interest rate that prevails in the medium-run equilibrium. Monetary policy can’t do it. 

Note: The argument of this post is important in the later post “Why Financial Stability Concerns Are Not a Reason to Shy Away from a Robust Negative Interest Rate Policy.” In that later post, you may find the update at the end, “Long-Run” vs. “Long-Term” helpful.