Rate's New Normal: Timing & Trajectory?

The neutral rate is not easily determined. Other factors can impact the economy, making it difficult to measure accurately.

Williams' earlier estimates got messed up by two other things: the GFC (which was a big financial crisis) and budget austerity (which means cutting back on spending). Because of these problems, even though interest rates were low, they didn't help the economy much. Williams's policies weren't working very well.

The model thinks monetary policy is very important. It says the neutral rate is lower than we thought.

Williams' recent predictions have the same problem: he uses current conditions, where inflation is high and real policy rates are significantly negative, in his incorrect calculation of the "normal" estimate.

People now factor in low rates when making financial decisions daily, like borrowing, lending, and assessing the worth of their assets. The opposite scenario - high rates - can be very bothersome.

The issue for policymakers is that there are two abnormal factors pushing in opposite directions regarding the idea of neutrality.

COVID caused the first problem. Monetary and fiscal policy did too much. This, along with supply-side issues, leads to high inflation. To fix this, interest rates should be higher than the neutral rate.

The second thing is the ongoing effect of low interest rates after the global financial crisis (GFC) decade. These low rates now affect how people make financial decisions, like borrowing, lending and asset values. Higher rates can cause trouble.

Low rates were beneficial for investors as they used this opportunity to get loans. Home borrowers also received the benefit of low rates as it allowed them to take bigger mortgages without worrying about their cash flows. Savers bought long-term bonds even though the yields were low. Some individuals took risks to get higher returns. Low rates led to an increase in mergers and acquisitions and share buybacks. Speculators were able to get loans cheaply to earn money but also incurred risks.

The sudden inflation in 2021 stopped the environment abruptly. Lots of people were not ready for the needed change in interest rates for the inflation to reach its target.

People think policy rates should go up more than inflation, even if there's no clear neutral rate.

Central banks didn't change policy rates because they were careful about returning to normal. They took small steps because it's complicated.

People in charge knew that just a small change in policy to fight inflation would cause problems for households, businesses, and finance. This means there needs to be time for everything to even out again.

The US Fed rate is barely positive in real terms. We will slowly return to low inflation. It will take a long time.

The neutral rate is important. Interest rates went up 10 times in the US, but started very low. They are still low compared to past times. The interest rate is the cost of buying things now instead of later. It has to be positive in normal times.

If the economy doesn't stay in a long recession, people who think they'll get lower real rates later may not be happy.

Policymakers need to pay attention to a key message. If the policy rate strays too far from Wicksell's neutral rate, it will mess up financial choices. Fixing the mess later on won't be easy.

It's best to acknowledge the boundaries of monetary policy. Keep policy rates positive and close to neutral in real terms.

Ben Bernanke tried to see how much the Fed could do after the GFC. He did things like quantitative easing, forward guidance, and intervening in financial markets. But it didn't work out like he thought it would.