Did the Natural Rate Fall***?

Paul Krugman describes the natural rate of interest as "a standard economic concept dating back a century; it’s the rate of interest at which the economy is neither depressed and deflating nor overheated and inflating. And it’s therefore the rate monetary policy is supposed to achieve."

The reason he brings it up-- aside from obvious interest in what the Fed should do about interest rates-- is because a recent paper by Thomas Laubach of Federal Reserve and San Francisco Fed President John Williams has just provided updated estimates of the natural rate for the U.S. Laubach and Williams estimate that the natural rate has fallen to around 0% in the past few years.

The authors' estimates come from a methodology they developed in 2001 (published 2003). The earlier paper noted the imprecision of estimates of the natural rate. The solid line in the figure below presents their estimates of the natural real interest rate, while the dashed line is the real federal funds rate. The green shaded region is the 70% confidence interval around the estimates of the natural rate. (Technical aside: Since the estimation procedure uses the Kalman filter, they compute these confidence intervals using Monte Carlo methods from Hamilton (1986) that account for both filter and parameter uncertainty.) The more commonly reported 90% or 95% confidence interval would of course be even wider, and would certainly include both 0% and 6% in 2000.

Source: Laubach and Williams 2001

The newer paper does not appear to provide confidence intervals or standard errors for the estimates of the natural rate. As the figure below shows, the decline in the point estimate is pretty steep, and this decline is robust to alternative assumptions made in the computation, but robustness and precision are not equivalent.

Source: Laubach and Williams 2015

Note the difference in y-axes on the two preceding figures. If you were to draw those green confidence bands from the older paper on the updated figure from the newer paper, they would basically cover the whole figure. In a "statistical significance" sense (three stars***!), we might not be able to say that the natural rate has fallen. (I can't be sure without knowing the standard errors of the updated estimates, but that's my guess given the width of the 70% confidence intervals on the earlier estimates, and my hunch that the confidence intervals for the newer estimates are even wider, because lots of confidence intervals got wider around 2008.)

I point this out not to say that these findings are insignificant. Quite the opposite, in fact. The economic significance of a decline in the natural rate is so large, in terms of policy implications and what it says about the underlying growth potential of the economy, that this result merits a lot of attention even if it lacks p<0.05 statistical significance. I think it is more common in the profession to overemphasize statistical significance over economic significance.

Desire to Serve, Ability to Perform, and Courage to Act

Ben Bernanke’s new book, “The Courage to Act: A Memoir of a Crisis and its Aftermath,” was released on October 5. When the title of the book was revealed in April, it apparently hit a few nerves. Market Watch reported that “Not everyone has been enamored with either Bernanke or his book-titling skills,” listing representative negative reactions to the title from Twitter.

On October 7, Stephen Colbert began an interview of Bernanke by asking about his choice of title for the book, to which Bernanke responded, “I totally blame my wife, it was entirely her idea.”

I hope to comment more substantively on the book after I get a chance to read it, but for now, I just wanted to point out a fun fact about the title. The phrase “courage to act” is the third of three parts of the U.S. Air Force Fire Protection motto: “the desire to serve, the ability to perform, and the courage to act.”

Bernanke has made an explicit analogy between monetary policymakers in the crisis and fire fighters before. In a speech at Princeton in April 2014, he said, “In the middle of a big fire, you don’t start worrying about the fire laws. You try to get the fire out.” On his blog, Bernanke described a bill proposed by Senators Elizabeth Warren and David Vitter as “roughly equivalent to shutting down the fire department to encourage fire safety.” The appeal of the fire fighter analogy to technocratic policymakers with academic backgrounds must be huge. How many nerds’ dreams can be summed up by the notion of saving people from fire…with your brain!

Do we want our policymakers “playing fire fighter”? Ideally, we would be better off if they were more like Smoky the Bear, preventing rather than responding to emergencies. Anat Admati, among others, makes this point in her piece “Where’s the Courage to Act on Banks?” in which she argues that “banks need much more capital, specifically in the form of equity. In this area, the reforms engendered by the crisis have fallen far short.”

Air Force Fire Protection selected its motto by popular vote in 1980. The nominator of the motto was Sargent William J. Sawyers. A discussion of the new motto in the 1980 Fire Protection Newsletter reveals additional dimensions of the analogy, as well as its limits: 

The motto signifies that the first prerequisite of a fire fighter is "the desire to serve." The fire fighter must understand that he is "serving" the public and there is no compensation which is adequate to reward the fire fighter for what they may ultimately give - their life. The second part of the motto is absolutely necessary if the fire fighter is to do the job and do it safely. "The ability to perform" signifies not only a physical and mental ability but also that knowledge is possessed which enables the fire fighter to accomplish the task. The final segment of the motto indicates that fire fighters must have an underlying "courage to act" even when they know what's at stake. To enter a smoke filled building not knowing what's in it or where the fire is, or whether the building is about to collapse requires "courage." To fight an aircraft fire involving munitions, pressure cylinders, volatile fuels, fuel tanks, and just about anything else imaginable requires "courage."

The tripartite Air Force Fire Protection motto emphasizes intrinsic motivation for public service and personal competence as prerequisites to courage. Indeed, in the Roman Catholic tradition, courage, or fortitude, is a cardinal virtue. But as St. Thomas Aquinas explains, fortitude ranks third among the cardinal virtues, behind prudence and justice. He writes that “prudence, since it is a perfection of reason, has the good essentially: while justice effects this good, since it belongs to justice to establish the order of reason in all human affairs: whereas the other virtues safeguard this good, inasmuch as they moderate the passions, lest they lead man away from reason's good. As to the order of the latter, fortitude holds the first place, because fear of dangers of death has the greatest power to make man recede from the good of reason.”

Courage alone, without prudence and justice, is akin to running into a burning building, literally or metaphorically. It may either be commendable or the height of recklessness. As we evaluate Bernanke’s legacy at the Fed, and the role of the Fed more generally, any appraisal of courage should be preceded by consideration of the prudence and justice of Fed actions.

Other mottos that were nominated for the Air Force Fire Protection motto are also interesting to consider in light of the Fed-as-fire-fighter analogy. Which others could Bernanke have considered as book titles? The proposed mottos include:

• Let us know to let you know we care. 
• Wherever flames may rage, we are there. 
• Duty bound. 
• To serve and preserve. 
• To intercede in time of need. 
• When no one else can do. 
• Duty bound when the chips are down. 
• For those special times. 
• Forever vigilant
• Honor through compassion and bravery.
• To care to be there. 
• Prepared for the challenge. 
• Readiness is our profession.
• To protect - to serve
• Without fear and without reproach.
• Fire prevention - our job is everyone's business
• Support your fire fighters, we can't do the job alone.