Fed President Williams on the natural rate of interest - r-star


The Federal Reserve Bank of San Francisco earlier this week published an adapted speech by their president John C. Williams. In this speech, of May 15th, he addressed r-star, the natural rate of interest, and how he thinks it will fare over the next decade.

Firstly, he notes the main drivers of the decline in r-star over the past twenty years; changes in demographics, a slowdown in productivity growth, and heightened demand for safe assets (Williams 2016, 2017). In uni I was told that you should always use more than one source, so there's nothing funny about citing two of your own papers.

Williams then notes that the US is doing quite well, with decent GDP growth, low unemployment, and inflation nearing the 2% mark. Williams expects this expansion to continue, and believes the US can expect an average 2.5% growth this year and the next.

Then the most interesting part of the speech;

The optimism about r-star is (sadly) misplaced

It’s these strong tailwinds that are leading some people to believe that we’ll see r-star move back up. But, as I said, this optimism is, sadly, misplaced.

It’s time to return to our trio of demographics, productivity growth, and the global demand for safe assets.

When it comes to demographics, the thing I hear discussed is that the baby boomer generation is a peculiarity that will slowly work its way out of the data. That’s a polite way of saying that, once my generation has retired, labor force growth will return to the speed of recent decades. But research by my colleagues at the San Francisco Fed reveals that our increased longevity and propensity to save are the key demographic drivers keeping r-star low, and they’re not about to reverse (Carvalho, Ferrero, and Nechio 2017).

People living longer and saving more are two trends I would like to see continue! But they do both spell bad news for the fortunes of r-star.

The second thing I hear discussed is that there’s more cause for optimism around productivity growth because of the fiscal stimulus and, more specifically, the tax cuts. In principle, if businesses have a smaller tax burden, they’ll have a greater incentive to invest in capital equipment and research and development, which will drive productivity growth.

Although I agree that lower tax rates on businesses should spur greater investment and productivity, the resulting effect on r-star is likely to be relatively modest. By my own calculations, we can expect the fiscal stimulus to increase r-star over the next decade by no more than 0.25 percentage point. This modest effect is in part because the tax cuts are front-loaded—that is, they have a larger effect on growth in the next few years than in later ones (Mertens 2018).

In addition, it’s important to remember that r-star is affected by global economic conditions and not just those in the United States. A bump in U.S. growth improves global growth, but if other countries don’t follow suit, the effect on r-star will be relatively modest.

The third leading factor in terms of a rising r-star is the demand for safe assets. The theoretical argument that, with such strong economic conditions, we should see the appetite for riskier investments increase, pushing up interest rates overall, makes sense. But that’s not what’s played out in the data, at least so far.

This leads Williams to conclude;

These three issues—demographics, productivity growth, and the demand for safe assets—all point to an r-star that’s set to hold its position low in the sky for quite some time.

Please find his full comment here


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