Welcome to this exploration of the natural rate of interest—a concept that holds a pivotal role in shaping modern monetary policy. This article aims to offer a comprehensive understanding by delving into its historical context, the impacts of fluctuating rates on different demographic groups, and insights from renowned economists. Whether you're a student of economics, a policy enthusiast, or just someone interested in understanding the financial forces that affect our lives, this article is for you. Let's dive in.
Throughout the latter half of the 20th century, interest rates were influenced by a variety of global events and economic policies:
Oil Shocks and Volcker Rule: The 1970s were marked by oil shocks which led to disruptions in global economies, resulting in stagflation in many Western countries. Central banks responded by raising interest rates to control inflation. The early 1980s saw Federal Reserve Chairman Paul Volcker's aggressive interest rate hikes to combat inflation, resulting in a recession but eventually curbing inflation. 70s Oil Shocks
The Great Moderation: Spanning from the mid-1980s to 2007, this period was characterized by reduced economic volatility, attributed by some to improved monetary policy and by others to structural economic changes. Delve into the Great Moderation
The Great Moderation and liquidity traps are closely related. During periods of low volatility like the Great Moderation, central banks may find themselves in a liquidity trap, a situation where traditional monetary policy tools lose efficacy due to very low interest rates. The idea is that when interest rates are so low that most consumers or businesses would prefer to hoard cash, rather than invest or spend. In such cases, any rate cuts intended to stimulate the economy might be less effective. This becomes a significant concern when the central bank needs to fight off negative economic shocks. From this point of view, a higher interest rate that manages a low unemployment rate allows more effective action from Monetary Policy. More on the Liquidity Trap
Different Demographics
In line with Keynes' "euthanasia of the rentier," higher interest rates could significantly affect those who rely on fixed income or passive investments. While higher rates benefit savers, they could be detrimental to borrowers and can also impact housing markets, thereby affecting a broad range of demographics. Anyone who purchased a home in the COVID era with a variable rate is likely spending nights in bed dreaming of a different world. Americans are familiar with long-term fixed rates, supported by the GSEs like Fannie Mae or Freddie Mac that enhance liquidity and credit access to potential homeowners. Europe does not have 30-year mortgage rates, the standard is a variable rate. Theoretically, the tradeoff for higher mortgage rates are cheaper home prices but the low supply of available homes has first time homebuyers stuck in a nightmare of expensive homes, expensive interest payments on house debt. Many families who wanted to have a single family home with a yard are now compromising for multifamily gingerbread apartments, thin walls and a pipe maze on the ceiling. Euthanasia of the Rentier
Banking Mini-Crisis and Corporate Consolidation
The steep rate hike regime had a larger impact for banks with heavy allocations to Treasury and Mortgage-Backed Securities (MBS). The value of these assets sunk significantly, affecting the balance sheets of these banks to the point of insolvency, with a potential to trigger a bank run. News spreads lightning fast, some anxious depositors begin pulling out money which triggers the vicious circle towards insolvency. The Federal Deposit Insurance Corporation took unprecedented action in extending its insurance protection to all of the depositors at the affected banks, SVB and Signature Bank. Their justification was that the collapse of a few of these mid-sized banks could result in significant losses for other financial services firms, sending an already fickle economy into the all-so dreaded recession. The actions, taken alongside the Fed's cash loans, received an uproar from moral hazard monitors. They argue that taxpayers should not be bailing out high worth individuals or companies if they hadn't managed their own risk. So far, it seems the policies have had their intended impact but it would be foolish to dismiss further repercussions. Given a recent yield inversion, as anxious investors and institutions pour their funds into money markets, it is possible another rate hike could cause a deflationary shock that sends the US economy into recession with potential runs for small and medium sized banks.
Who was bailed out from SVP collapse?
John Maynard Keynes: Beyond advocating for government spending, Keynes might have discussed the "euthanasia of the rentier". This concept, especially relevant in today's digital age, critiques profits earned through passive investments. Euthanasia of the Rentier
Milton Friedman: Recognizing the importance of money supply, Friedman's natural rate hypothesis suggests long-term growth is largely insulated from monetary policy. Friedman's Monetary Theory
Friedrich Hayek: Hayek's views on knowledge dispersion underscore the limitations of centralized economic interventions. Hayek was renowned for scorning centralized power in government or central banks because of the moral hazard. His most famous work, The Road to Serfdom, gained praise for articulating the threats of strong central control and their adverse affects on liberal societies.Hayek's Economic Theory
As we explore the complex world of interest rates, we find ourselves in uncharted territory. While the Federal Reserve's recent policies appear to be accomplishing their intended soft landing, the waters remain muddy. Recession fears have been lingering, exacerbated by signs like recent yield curve inversions. These indicators often precede economic downturns, making them impossible to ignore.
Policymaker's Dilemma Policymakers face a Herculean task. The delicate balance of maintaining low unemployment, controlling inflation, and ensuring financial stability has never been more challenging. The recent mini-crises in the banking sector and the ongoing debates about moral hazards signal that we're not out of the woods yet.Despite the Fed's optimistic outlook, cracks are beginning to show. Whether these are minor fissures or warning signs of a larger quake remains to be seen. What is clear is that these uncertainties merit close monitoring and could potentially disrupt the global financial landscape.
So, what's next on the interest rate horizon? That's a subject for ongoing discussions and certainly a topic we'll revisit. For now, all eyes are on the Federal Reserve and global economic indicators as we navigate these muddy waters.