A quarter of a percentage point interest was added in the United States and in the eurozone this week. That now brings the US interest rate to between 5 and 5.25 percent, and the main European at 3.25 percent. Inflation is still far too high. And central banks try to quell them with higher interest rates.
The system of the US central bank, the Federal Reserve, is now on pause. The European Central Bank continues to increase. It takes a year or more before a change in interest rates has an effect on the economy, and at some point it becomes wise to also look at what all those interest rate hikes that have been implemented since last year are doing so far.
But how do you know whether the interest rate is indeed high enough? The two most important things to take into account are the momentum of the economy and the level of inflation. To start with the first: if the economy is growing faster than usual, tightness may occur. In the labor market, for example, which causes wages to rise rapidly. Or tightness in the market for products or services, when there is more demand than supply and prices go up. An economy that is growing long above its ‘cruising speed’ often requires higher interest rates to slow it down. Or, conversely, a lower interest rate if growth has been substandard for a long time and some monetary stimulation may be appropriate.
The second thing to take into account is the rise or fall in prices themselves: inflation. If, like most central banks, you’re aiming for an inflation rate of 2 percent and inflation is higher than that, that’s a reason to raise your interest rate and reduce that inflation. If inflation is low, interest rates can go down.
These two—that is, relative economic growth relative to ‘normal’, and relative inflation relative to target—are part of a simple rule of thumb for central bankers: the Taylor Rule. This rule prescribes how high interest rates should actually be to achieve price stability. It was invented in 1992 by American economist John Taylor. Here you see him:
As the chart shows, the Taylor Rule has been quite turbulent when compared to the actual changes in interest rates that central banks have made over the past 20 years. In fact, interest rates should have been negative shortly after the financial crisis of 2008-2009. And to curb today’s very high inflation, interest rates would have to be much higher. But central bankers can’t go as wild as the Taylor Rule says. That would hurt the economy quite a bit. It benefits more from gradualism.
The Taylor Rule is not just about measuring how the economy and inflation fare in practice. There is also an important other variable in the formula: a starting point called the ‘neutral rate’, sometimes also ‘equilibrium rate’ or in English the ‘natural rate’. Economists write him as R*. This concerns the ideal interest rate that should apply if the economy is in complete equilibrium, with, for example, unemployment that is low, but not too low. The interest rate is different for each country. Compared to that ideal, you could then determine whether the interest rate that you, as a central bank, hold back the economy and inflation. Or just stimulates.
Central bankers have always paid close attention to R*. It is suspected that this theoretical R* has fallen structurally in the decades since 1980. And thus justified the similarly structural decline in central bank policy rates.
That’s the past. The International Monetary Fund recently conducted an extensive study into the future development of R*. The line is slightly upwards for industrialized countries and downwards for emerging countries. It will soon be pretty low everywhere.
That all sounds very rational and substantiated. But the problem is: nobody knows how high the neutral interest rate is at the moment. Because there are different methods to calculate it. And that is starting to wring.
Back in 2018, the regional Fed of Richmond published a critical article with the (well found) title: The Fault in R Star – adapted from the film of the same name. The idea: maybe R* didn’t work so well anymore, now that these were such unusual times, and growth and inflation had fallen so low after the financial crisis.
All that uncertainty shows in R*’s calculations, which have huge margins. The IMF summarizes this as follows:
And then there were the shocks of the pandemic, the turbulent economic recovery that followed and the price shock caused by the Russian invasion of Ukraine. Can you still calculate R*, which should be the neutral interest rate, in such macroeconomic climate change? The variables in the formulas are perhaps much too wild for that.
You search in vain for their recent calculation of R* on the US central bank’s site: you come across the statement that it has been suspended since the end of 2020. Economists at ING already stated last year that R* has become an “invisible moving target”. As if blindfolded central bankers start a boxing match.
How does that continue? Just as central bankers are deciding whether their interest rate hikes, now or soon, are sufficient, an important navigational tool seems to have fallen away. A sailor sails on the starry sky. But R*, writes the Richmond Fed, may no longer be suitable: a star that fades the closer you get to it.