Productivity puzzles and the neutral rate of interest

Monetary policy frameworks come under pressure

The decision by US president Donald Trump to nominate Jerome Powell to replace Janet Yellen as chair of the Federal Reserve Board may come as a surprise to some, given Yellen’s steady stewardship of the Fed since 2014. Unemployment in the US is at a 16-year low, consumer price inflation appears to be under control, the US economy is in its ninth consecutive year of growth, and the Fed has started to reduce some of its $4.5 trillion balance sheet with little incident to date.  

The US president also broke with a non-partisan tradition of reappointing Fed chairs selected by the previous administration that has existed since Ronald Reagan reappointed Paul Volcker in 1983. Powell, a Fed governor since 2012, is not expected to deviate sharply from existing Fed monetary policy, as he has never dissented from the prevailing Federal Open Market Committee view. However, his appointment appears to be part of a broader trend of handing top central banking jobs to individuals with wider experience outside economics. Trump noted Powell’s “extensive private-sector experience” and ability to bring “real-world perspective” when nominating him.

Negative sentiment against economists first emerged in the aftermath of the global financial crisis – when many economic models failed so spectacularly. But the current pushback against economic specialists comes at a time when growth is expanding. Indeed, the mood among many policymakers at the International Monetary Fund/World Bank autumn meetings in Washington, DC, this year was notably upbeat, with some lauding ‘synchronised global growth’ as the GDP rates of the US, China, Japan and Europe picked up.

While the growth numbers are higher, they remain historically weak – and they may be short-lived. European Central Bank president Mario Draghi warned at Jackson Hole that the recent recovery in growth may be cyclical, and ultimately would converge on lower growth. This may explain why the ECB extended its bond-buying programme – at a reduced pace of €30 billion ($34.9 billion) a month – until at least September 2018.  

Indeed, part of the problem facing central bankers is how they calibrate (and communicate) policy in an environment where the neutral rate of interest – the real rate of interest that equalises savings and investment in a steady state – is declining. Research by Federal Reserve Bank of San Francisco president John Williams and Thomas Laubach estimates the US neutral rate fell from around 3% in 2000 to around 0% now, with other research showing a similar pattern in Europe and Canada. In her article examining Japan’s monetary accommodation in light of a falling natural rate, Sayuri Shirai points to Bank of Japan studies that indicate the Japanese neutral rate hit 0% in 2000 and the 10-year neutral rate currently stands at 0%.

Divided opinion

It is an important yet complex issue that is little understood by many outside the economics profession, including politicians and the general public. Even among economists, opinion is divided – especially over the scale of the contributory factors that caused the fall in the neutral rate, whether the decline will reverse anytime some soon and the associated implications for monetary policy.

In an interview with Central Banking, Williams says the biggest factor behind the decline in his model is plunging productivity. Others, however, have challenged the scale of productivity’s decline. Hal Varian, chief economist at Google, tells Central Banking in an interview that GDP figures contain obvious inaccuracies, especially when they are related to the technology sector. He points to basic issues such as the failure to value the benefit of multi-core computer processors that offer a powerful advantage over single-core processors when it comes to cloud computing.

A bigger concern for Varian is how statistics deal with ‘free’. He points to the fact that a single smartphone may contain up to 30 tools that people now get for free, which they previously had to pay for separately. This raises some oddities in productivity statistics. For example, the price of a GPS system has fallen from around $1,000 to nothing. As the decline in prices took place, real GDP increased until the price hit zero. “Then it’s no longer in GDP. It no longer has any quality improvement,” says Varian. There are other issues involved, such as the treatment of imports and exports, as well as the measurement of intellectual property such as software.

Williams says research by John Fernald and others discovered that inaccuracies when measuring the effect of technology on GDP “were as big, or probably even bigger, in the past”. However, Varian believes miscalculation is only part of the issue, and even this accounts for between 40 to 60 basis points of underestimation of US GDP.

There is also the role of demographics. Varian believes demographics will play an important – and under-researched – role as ‘baby boomers’ start to retire and the ability for more women to enter the labour force has become saturated. While Williams asserts that demographics are important, he says much will depend on whether retirement ages increase in proportion to increases in life expectancies, along with the associated impacts on savings. At the very least, he expects there to be no major reversal in the falling natural rate in the US over the next decade or so.

As a result, Williams proposes that central banks systematically review their monetary policy frameworks – notably 2% inflation targets – to ensure they are fit for purpose. One of his concerns is that current central bank policy frameworks are unable to handle the equivalent of a 4–5 percentage point cut in interest rates in the event of a recession. The introduction of higher inflation targets – perhaps 4% – or price-level targets are two potential options that could help to tackle such an issue.

Indeed, in a world where quantitative easing and policy spillovers and spillbacks have become the norm, there may be “mutual benefit” for countries to work “together” to change their price-stability policies”, says Williams. Collaboration could prove difficult, as Bank for International Settlements general manager Jaime Caruana indicates. But Williams believes a co-ordinated shift to new mandates might be possible if there was a “true policy strategy debate”.

While co-ordination may be tough, more central banks need to follow Canada’s lead and carry out a regular review of their operating frameworks. The result may be that they do not see a fall in productivity at all once research and development, advertising, building up clientele, brand name, technology, know-how embodied in people within the organisation are added together, as expressed by Nobel laureate Ed Prescott. But without testing their monetary policy frameworks and assumptions, it is difficult to know.

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