Normalisation begins in Washington

As expected, the Reserve Bank of Australia left the official short-term interest rate unchanged after this week’s board meeting.

The decision reflected the concern recently expressed by the bank’s deputy governor, Phil Lowe, that rate-cutting was no longer delivering the degree of stimulus to activity that it had in the past.

It also reinforced the oft misunderstood reality, expressed by former Federal Reserve chairman Ben Bernanke in his first blog for the Brookings Institution, that the idea low interest rates are set by the central bank is true only in a very narrow sense.

In the US, the Federal Reserve sets the benchmark nominal short-term interest rate as the RBA does in Australia.

But as Bernanke said, “What matters most for the economy is the real or inflation-adjusted interest rate (the market or nominal interest rate minus the inflation rate.)

“The Fed’s ability to affect real rates of return, especially longer-term real rates is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth – not by the Fed (or the RBA in Australia).”

Canberra is not without some economic clout, but it is inhibited in its economic management capacity by the fact that Australia is a medium-sized open economy with an export base overwhelmingly focused on commodities.

The political environment has evolved away from infrastructure investment towards servicebased activities that reflect our changing demographics like welfare, health and education.

China gave us a historic boom, but that is over. Only the US has the firepower to lift the global economic tempo.

But the US economy has reached an inflection point. It has a central bank sailing into unchartered waters as it sets out to normalise its monetary policies.

Success is by no means assured.

The historically low level of interest rates is indicative of a worried and apprehensive global marketplace.

Ben Bernanke points out that these low interest rates are not a short-term aberration, but part of a long-term trend.

The task of normalising monetary policy – a project which will, if successful, pave the way for a wider economic renaissance – falls to the US Federal Reserve.

Its strategy, as outlined in late March by the bank’s chair Janet Yellen at a San Francisco conference, will involve targeting what is called the equilibrium real rate. It’s also called the Wicksellian rate. 

This, as defined by Yellen, is typically viewed as the level of short-term interest less inflation, estimated to be consistent with maximum employment and stable inflation in the long run, assuming no future disturbances to the economy.

Many factors affect the equilibrium rate that can and does change over time.

Implementing such an economic strategy is not unlike Deng Xiaoping’s description of crossing a river by feeling the stones with your feet.

However, that is how the US Federal Reserve intends to guide its economy back to the ‘new normal for monetary policy’.

The prime role to be played by the ‘equilibrium real federal funds rate’ was illustrated at the simplest level by being referred to no fewer than 25 times during the course of Yellen’s San Francisco speech.

Yellen said that she and her Federal Open Market Committee (FOMC) colleagues anticipated that a rather gradual rise in the federal funds rate will be appropriate over the next few years, conditional on their baseline forecasts for real activity, inflation and other aspects of the economy’s performance.

She told her audience, “I have emphasized one key rationale for such a judgment – namely, that the equilibrium real federal funds rate is at present well below its historical average and is anticipated to rise only gradually over time as the various headwinds that have restrained the economy continue to abate”.

“If incoming data supports such a forecast, the federal funds rate should be normalised, but at a gradual pace.”

Yellen is conscious of the risks involved.

Nobody can look at the universally low interest rate regimes around the world without having qualms about the dismal spirits of the financial markets.

Yellen conceded that substantial uncertainty surrounds all estimates of the equilibrium real interest rate. Market participants appear to be fairly pessimistic about the odds that it will rise significantly over time.

Moreover, she noted some recent studies have raised the prospect that the economies of the United States and other countries will grow more slowly in the future as a result of demographic factors and a slower pace of productivity gains from technological advances.

Yellen said, “At an extreme, such developments could even amount to a type of ‘secular stagnation,’ in which monetary policy would need to keep real interest rates persistently quite low relative to historical norms to promote full employment and price stability, absent a highly expansive fiscal policy.”

The secular stagnation hypothesis offers an alternative explanation for the slow recovery of most economies from the global financial crisis.

Actually, it is an economic hypothesis that was originally formulated by the US economist Alvin Hansen in the 1930s.

It has been resurrected by former US Treasury secretary Larry Summers as an alternative, perhaps complementary is a better description, to the global savings glut thesis developed by Ben Bernanke when he was chairman of the Federal Reserve.

Secular stagnation describes a situation where investment is constrained when the potential return on investment falls below the zero lower bound level. In such circumstances, no investment takes place.

The threat posed by secular stagnation is difficult to quantify. One of its more ominous features can be seen in the decline in participation in the US work force.

A significant contributor to this development is the increase in workplace automation. Artificial intelligence has moved robots from doing repetitive tasks to much more sophisticated activities in the fields of health and law.

Secular stagnation may have the potential to be an agent of disruptive and structural change. As such, it poses a much greater threat to normalising the US economy than the global savings glut.

Essentially, this Bernanke explanation for the slow recovery from the GFC appears to be a cyclical problem rather than a structural one.

Let’s hope so because Janet Yellen and her colleagues at the FOMC have a lot riding on their shoulders.

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Max Walsh


Max Walsh was for many years one of Australia’s top economic and political commentators, highly regarded as a journalist, author and broadcaster. Throughout his career, Max was involved in all dimensions of the media industry, which has encompassed positions with two of Australia’s largest publishing companies and television networks.

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