The Myth of the Equilibrium Interest Rate

by
Brendan Brown
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“Fast thinking” is a corrupting short-cut in mental processes which the late Daniel Kahneman identified by experiments in financial decision-making. Fast thinking plagues the market-place as it responds to the new threat of responses to Fed-led inflation. That threat had emerged even before the post-pandemic inflation starting in late 2022 cooled from its peak levels. The most recent surge in prices had materialized even though its symptoms in goods markets were tamed by reversal of earlier supply side dislocations.

An often-reported theme illustrating the current inflation angst suggests the Powell Fed will start to cut its policy rate by Summer 2024 out of misplaced complacency or due to political calculation. According to some of the inflation worriers, that rate policy would jar with a US economy which is remarkably and persistently strong—at least according to the army of data watchers whose size has swollen in response to the Fed’s official mantra that its monetary decisions have become strictly “data-dependent.” 

Ex-Treasury Secretary (under Clinton) and Obama Chief Economic Adviser, Professor Larry Summers—now a top Bloomberg TV contributor—pronounces adamantly that the equilibrium interest rate has risen far above the level of the 2000s and 2010s. Hence the Fed’s plans for “normalizing policy rates” will likely aggravate inflation.

How is this an example of flawed “fast thinking”? In answering, we should recall Kahneman’s observations that the mind, in taking short-cuts to facilitate a rapid response (in this case to perceived inflation danger), ignores limits of rationality. Examples of such flaws include over-reliance on small sample sizes and on dubious, though currently plausible, hypotheses. 

Small sample size is evident in any contention about equilibrium interest rates. There are few relevant non-overlapping long periods for the purpose of estimation. And, the concept of an equilibrium rate is itself a dubious theoretical construct. Nevertheless, the Fed under the present monetary regime embraces it fully albeit in the convoluted form of “neutral rate analysis” or “staring at r star.” 

The Dubious “Equilibrium Interest Rate”

The equilibrium interest rate, so far as it is knowable at all, could well have been abnormally high through much of the quarter century prior to the pandemic. Central banks led by the Fed (their choice to accept US hegemony was not inevitable—a subject beyond the present blog) piloted policy rates far below this for much of that time.

A key influence behind the high equilibrium interest rate level in 1995-2020 as hypothesized here was the fantastic boom (some would say ultimately bubble) in the building of global industrial supply chains. The digitalization revolution had enabled micro-managerial control over vast geographical and organizational areas. This was all in the context of China’s entry into the WTO (as recommended to Congress by President Clinton in 2000) and accelerated regional economic integration (including NAFTA AND EU expansion after fall of the Berlin Wall).

In a Free Market, Prices Would Have Fallen for 20 Years

Under a sound money regime—well-anchored by a base money pivot—consumer prices would have been falling through these two decades or more of revolutionary building of international supply chains. But none of this occurred under the actual two-percent inflation standard. 

Central banks piloted the policy rate to “counter the menace of deflation.” Virulent asset inflation became an additional driver of business spending including in this case not just of building international supply chains but also more broadly digitalization whether within the context of the unicorns or more specifically chasing the potential for monopoly rents as made possible by the new technology. 

One of the most extreme examples of such monetary distortion was under the Bernanke/Yellen Feds of 2013-17. The global commodity price bubble had burst. The bubble had been fueled originally by China’s extreme monetary and fiscal “stimulus” policies of 2009-12, only possible in the context of Fed-led monetary inflation. The plunge in commodity prices should have meant a period of falling consumer prices across a wide span.

Instead, We Got Massive Asset-Price Inflation

Instead, the Yellen/Bernanke Fed fueled a tremendous asset inflation, whilst boasting about a CPI inflation rate barely above zero. In turn the new momentum in US monetary inflation fed global investment spending booms whether the unicorns, big tech, and of course Chinese real estate. It is far from obvious, now that much of these once hot areas of investment spending, such as construction of international supply chains and Chinese property in particular, have gone into reverse. Thus, it is not clear why Summers should be correct in his hypothesis that the “equilibrium rate of interest” should have moved to a higher level.

In fact, we could be in a long stretch of time when this equilibrium rate has fallen compared to 1995-2020. And the actual colossal US fiscal debts and deficits do not contradict that conclusion. Record high US government debt financed eventually by different forms of crushing taxation— including crucially painful periodic levying of inflation tax and other forms of monetary taxation—are hardly a recipe for economic dynamism. Rather, these are the tell-tale features of once prosperous empires in terminal decline.

Government Regulations Stifle Growth

A distinctly non-dynamic scenario looms in the probabilistic future for the US and for much of the world economy in the aftermath of the Great Monetary Inflations through 1995-2024. Malinvestment in all its dimensions comes home to roost. Yes, artificial intelligence (AI) could be a spur to growth if indeed the forces of innovation turn out to be under the control of well-functioning invisible hands which find and develop new paths of economic fortune into the forest of the unknown. All of that is far from certain.

The now-long experience of digital technological revolution with its special characteristics—winner take all, suppression of free entry, corrosion of property (including data) rights)—argues for caution. The revolution has not been a great motor for living standards in general across the advanced economies, in contrast to undoubted gains for the developing economies as derived especially from the revolution in global supply chains.

And then we have the dismal prospects in the world’s second largest economy, China. Under unreformed statism and heavy financial repression where fears of future poverty—especially in old age—propel savings to record levels, this economy’s net surplus in goods and services trade with the rest of the world becomes hyper-giant. Massive flows of capital exports out of China are the corollary, bearing down on the global equilibrium level of interest rates.

A Dangerous Landscape Ahead

Time to call a spade a spade: when thinking slow rather than fast about inflation threat we should realize the concept of an “equilibrium interest rate” is of limited, if any, aid to our economic understanding—never mind the persistent popularity which it has enjoyed under fiat money regimes. Yes, in today’s unanchored monetary system central banks make key judgements about the policy rate’s relationship to the so-called neutral rate but much if not all of this is bogus – symptomatic of the present dark age of money.

Yet there is no prospect of monetary systems moving away from the present diktat of policy rates as set by the Fed. A falling trend of the policy rate, notwithstanding the protests of Professor Summers on Bloomberg TV, would tell us that the present celebration of US economic dynamism is ignoring deep counterforces at work.

Would this mean a less inflationary future than many now fear? No. But the high inflation ahead is likely to come in spurts of combustion—prices generally veering upwards and by far in response to supply shocks which meet with no monetary system resistance. And when the supply shocks go into reverse the Fed takes advantage of the situation to empower monetary inflation rather than allow prices to fall back in general back towards their pre-shock level.

Examples of such potential supply shocks include geo-political disruptions, pandemics, famine and other misfortunes sprung by Mother Nature, internal social and political chaos, and fiscal explosion. In effect we should expect Big Government including its Central Bank to fully exploit these episodes for the opportunity to levy bouts of painful inflation tax and so roll-back at least temporarily an inexorable growth in the real amount of its outstanding debt.

Image credit: Wikimedia.