FX International Payments
By Frances Coppola
To understand the implications of economists’ search for a “new normal” for r-star, first know that the Federal Reserve uses an estimate of this “neutral real interest rate” to help it determine the right setting for the Fed Funds Rate, which influences interest rates throughout the U.S. and, hence, the dollar’s exchange rate.
It’s easy to assume that the value of r-star can be estimated simply by reference to pre-crisis average interest rates. After all, if the economy has simply been temporarily shocked out of equilibrium, then r-star should be the same as before. When people talk about “normalizing” interest rates, often what they mean is returning to historical interest rate levels. Prior to the financial crisis, the average Federal Funds Rate was around 4 percent.2 The Fed’s inflation target is 2 percent: deducting 2 percent from 4 percent gives a value of about 2 percent for r-star.
But economists are now questioning whether this is the right approach. Nominal interest rates have dropped relentlessly since 1980 and are now at historically low levels. Many say that this long-term decline indicates a similar long-term decline in the value of r-star.3 This could mean persistently lower interest rates in the future—which, if this were the only variable that changed, would lead to a lower dollar exchange rate.
However, if interest rates are declining globally, not just in the U.S., then a lower r-star may not mean a lower dollar exchange rate. Indeed, if interest rates remain lower in other major countries than in the U.S., then the dollar exchange rate could remain strong over the long-term.
What is causing the long-term decline in interest rates? Noted economist Lawrence Summers has proposed a “secular stagnation” hypothesis in which the natural rate of interest was driven down by a persistent excess of savings over investment. Among the reasons Summers identified to support his hypothesis are a decline in the demand for large-scale debt-financed investment (for example, new tech ventures can be started up with little capital and may quickly develop large cash surpluses), falling price of capital goods (i.e., less capital is needed, for example, for office equipment and automobiles), persistently low inflation, and an accumulation of FX reserves by central banks.4
The economists Ricardo J. Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas identify global demand for “safe assets,” principally the sovereign debt of developed countries that issue reserve currencies, particularly the U.S., as a key reason for a persistently low natural rate of interest. Their argument is that demand for safe assets from developing countries, particularly China, outstrips the ability of these developed economies to produce them. “The signature of this growing shortage is a steady increase in the price of safe assets, necessary to restore equilibrium in this market,” they say. “Equivalently, global safe interest rates must decline, as has been the case since the 1980s.”5
In similar vein, Federal Reserve Governor Lael Brainard observes that “foreign consumption and investment are weak, while foreign demand for savings is high, along with an elevated demand for safe assets.”6
If these economists are right, then even if interest rates remain low, global demand for safe assets could mean a stubbornly high dollar exchange rate in the future.
Most economists have regarded r-star as an exogenous variable, meaning that it is natural to the economy rather than being a consequence of monetary policy. Thus, the aim of monetary policy is to bring the economy to the point where the interest rate set by the Fed converges with this “natural” r-star. But researchers at the Bank for International Settlement (BIS) have concluded that r-star may not be exogenous after all—the value of r-star may be a consequence of monetary policy itself. This is where the implications for FX risk management and the dollar exchange rate could be profound.
According to the BIS research paper, “If monetary policy, through its influence on the financial cycle, can affect real output and real interest rates persistently over time, then it is not possible to define a natural rate independently of the monetary policy rule.”7 This could mean that there is no single real rate of interest at which the economy is in equilibrium. The “neutral interest rate” may be nothing more than outcome of the decisions made by the central bank and market participants.
Indeed, it could simply be that investor expectations are causing the rate of interest to decline. In his General Theory, the economist John Maynard Keynes commented that future interest rates are simply whatever investors expect them to be: “It might be more accurate, perhaps, to say that the rate of interest is a highly conventional, rather than a highly psychological, phenomenon. For its actual value is largely governed by the prevailing view as to what its value is expected to be.”8 In other words, if investors think future interest rates will be low, they will be low.
However, this doesn’t mean that there is no role for Fed interest rate policy. Investors may respond to Fed decisions regarding the level of the Fed Funds Rate, especially if the Fed indicates a future expected path. If Fed interest rate decisions help to determine r-star rather than simply responding to it, then policymakers perhaps bear even greater responsibility in their decision-making. The BIS researchers warn that policy errors could set the economy on an unsustainable path, leading to financial crisis and lasting economic damage. They advise that monetary policy decisions should aim to maintain financial and economic stability.
Fed monetary policy decisions using equations such as the Taylor Rule have relied on the existence of a “natural” or “neutral” rate of interest, r-star, that can be reliably estimated and remains broadly stable over time. But many economists now think that r-star is falling, for a variety of reasons. And some economists even question its existence as an independent variable against which to cast policy. If r-star is no longer a reliable guide to monetary policy decisions, then the Fed may be in uncharted territory, and there may be no “new normal” settings for monetary policy. This could affect the dollar’s exchange rate in unpredictable ways, creating uncertainty for businesses.
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Goodhart’s Law,” Wikipedia; https://en.wikipedia.org/wiki/Goodhart%27s_law
2. “The ‘New Normal’ And What It Means For Monetary Policy,” Brainard; https://www.federalreserve.gov/newsevents/speech/brainard20160912a.htm
3. “What anchors for the natural rate of interest?” Borio, Disyatat & Rungcharoenkitkul, https://www.bostonfed.org/-/media/Images/research-conference-2018/papers/what-anchors-for-the-natural-rate.pdf
4. “U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound,” Summers; http://larrysummers.com/wp-content/uploads/2014/06/NABE-speech-Lawrence-H.-Summers1.pdf
5. “The Safe Assets Shortage Conundrum,” Caballero & Farhi; https://scholar.harvard.edu/files/farhi/files/document_11.pdf
6. “The ‘New Normal’ And What It Means For Monetary Policy,” Brainard; https://www.federalreserve.gov/newsevents/speech/brainard20160912a.htm
7. “What anchors for the natural rate of interest?” Borio, Disyatat & Rungcharoenkitkul, https://www.bostonfed.org/-/media/Images/research-conference-2018/papers/what-anchors-for-the-natural-rate.pdf
8. “The General Theory of Employment, Interest, and Money,” John Maynard Keynes http://cas2.umkc.edu/economics/people/facultypages/kregel/courses/econ645/winter2011/generaltheory.pdf