Normalising monetary policy – where should the neutral policy rate be?

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Since the Lehman crisis in 2008, most OECD countries have been through a prolonged period of exceptionally low interest rates, accompanied by negative monetary policy rates and extensive quantitative easing (QE) programmes.

This super-easy monetary policy has helped the world economy to heal and the pace of global GDP growth is now picking up. As slack diminishes and economies move towards equilibrium, monetary policy also needs to be normalised. But what is ‘normal’?

The world is not what it was 10 years ago. There have been substantial structural changes over that time that have resulted in the ‘new normal’ policy rate being lower than the ‘old normal’ one. But how much lower should this neutral policy rate be?

The most obvious changes that have influenced monetary policy in OECD countries are:

1) Significantly higher debt levels, which have made economies more sensitive to interest rates and less resilient in the face of higher interest rates.

2) Declining unemployment even at moderate GDP growth rates, which indicates that the potential GDP growth rates have declined.

Should both these changes be structurally-based, it would render the ‘new normal’ policy rate lower than the ‘old normal’ one. To analyse whether this is true, and if so, how much lower the new neutral policy rate is, I have focused on how the potential GDP growth rate of a given economy has changed over the last decade. As the potential GDP growth rate is often seen as moving in tandem with the neutral policy rate, any changes to the former would engender changes in the latter.

There are several reasons why the potential GDP growth rate and the neutral policy rate are linked. One is that the potential growth rate is that which applies when an economy is in balance – i.e. when inflation is stable and on target and all resources are fully employed. When that is the case, the policy rate should also neutral.

Another reason is that the potential GDP growth rate can be seen as a proxy of investment return for an economy that is in balance. Although the investment bears some risk (while the policy rate is risk-free), it reflects the return of a well-diversified investment from which the policy rate should not deviate too much.

A third reason is that the structural factors which affect potential GDP growth also affect the overall economy. For example, there is reason to expect that the potential growth rate in the OECD area has declined due to lower total factor productivity. If this is correct, then investment demand is also likely to decline, which would reduce the need to raise policy rates.

An obvious problem with tracking potential growth rates is that the variable is unobservable. We thus need to formulate a model that describes the properties of potential growth. To do this we have turned to Arthur Okun’s paper from 1962. Okun focused on the relationship between economic growth and unemployment. He showed empirically – back in the early 1960s – that for every one percent increase in unemployment, GDP growth is likely to be two percent lower than its potential rate. I have repeated this analysis using updated data for the US. Exhibit 1 shows that the relationship between changes in GDP growth and the unemployment rate still holds.

Exhibit 1: The relationship between changes in GDP growth and the unemployment rate still holds

neutral policy rate

Source: BEA, BLS, as of 8 June 2017

The above relationship is called Okun’s Law. There have been several modifications to this since its launch in the 1960s. I have used Okun’s law according to the following two formulas:neutral policy rate

From these formulas, I can estimate the real potential growth rate in an economy as well as the NAIRU (Non-Accelerating Inflation Rate of Unemployment), which is where the unemployment rate should be when the economy is in equilibrium. The potential growth rate is the growth rate when unemployment is unchanged, which implies that the ratio from the first equation defines the real potential growth rate. a2 in the second equation defines the level of the NAIRU. I divided data into two samples, one long term (1949-2016) and one short term (1995-2016), to analyse how the relationship has changed over time. I applied the regressions for US, eurozone, Sweden and Norway data accordingly. I used different starting points depending on the quality of the data I had access to.

The results are as follows (note that the growth in the two Nordic countries is higher than in the eurozone):neutral policy rate

The estimates show that the real potential growth rates have declined for most countries or regions by approximately 1 % and the potential growth is higher in the US than it is in the eurozone.

It also shows that the two Nordic countries, Norway and Sweden, have higher potential growth rates, closer to that of the US. Unlike the US and the eurozone Swedish potential GDP growth has not declined, indicating that there have been some structural improvements in the Swedish economy (the same perhaps also goes for Norway) which have enabled it to run counter to the global trend of falling potential growth rates.

If this were true, it would imply that the neutral policy rate for Norway and Sweden would be higher than that for the eurozone, which in turn would be likely to lead to a potential strengthening of their currencies. Higher expected long-term growth and stronger currency indeed makes the Nordics an attractive environment for investors.

The tendency of a declining potential growth rate in the US and the eurozone fits well with the general belief that the ‘new normal’ is about 1 % lower than it used to be in the pre-Lehman crisis era. The same goes for the estimates that US potential GDP growth is higher than the eurozone’s. The deviation is usually explained by the US economy being more flexible and dynamic.

The US Federal Reserve (Fed) was the first of the major central banks to start removing monetary stimulus. Its first goal is to reach monetary policy neutrality by winding down the QE programme and raising the policy rate. However, by how much should the Fed raise rates before monetary policy starts to constrain economic activity instead of support it, as it does currently?

From the estimates illustrated in the table above, the neutral policy rate should be somewhat below 4%. This is illustrated in Exhibit 2 below, where real potential growth is estimated from the Okun relationship, using recursive regression to capture the development over time and comparing it with the real policy rate in the US. Exhibit 2 shows that the real observed policy rate is below the potential growth rate most of the time.

Exhibit 2: Potential growth versus real policy rate

Source: Macrobond, Alfred Berg, as of 8 June 2017

This is to be expected, as the real policy rate is risk-free and hence has a slack economy during most of the period motivating a below-neutral policy rate. However, the two variables do not seem to align, which many  interpret as meaning that the relationship has weakened recently.

For this reason, we need to see whether factors affecting the supply and demand of capital would be a better means of explaining and predicting the neutral policy rate, which is what the second in this series of two papers will analyse.


Written on 8 June 2017

Ulf Torell

Senior portfolio manager, Swedish Tactical Asset Allocation

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