Bill Gross Forgets About the Natural Interest Rate

Like Paul Krugman, I am am puzzled by Bill Gross’ Op-Ed in the Financial Times. Gross argues that the low interest rates of the Federal Reserve are causing the financial system to deleverage. Thus, he concludes that Fed policy is actually hampering the recovery of the U.S. economy. Now I agree with Gross that Fed policy is hampering the recovery, but it is not because monetary policy has been too loose. Rather, it has been too tight.

What Gross fails to consider is that interest rates would be low now even if there were no Fed. This is because the economy is weak and as a result the natural interest–the interest rate consistent with economic fundamentals–is low. As I constantly tell my students, never draw any conclusions about the stance of monetary policy by looking just at the target policy interest rate. Instead, I tell them, look at the policy interest rate relative to the natural interest rate over the entire term structure. Given the large output gap and the economic uncertainty, the natural interest rate is currently low and may even be lower than the actual federal funds rate.

Now this discussion should not be a surprise for Bill Gross. PIMCO previously published a nice piece by Paul McCulley and Ramin Toloui on the neutral interest rate–another way of saying the natural interest rate–back in 2008 that argued the Fed may be slow to act and thus end up chasing down the neutral interest rate without ever getting to it. Here is an excerpt:

If the central bank does not act quickly enough – and financial conditions deteriorate further – the central bank may end up just chasing the neutral rate down without ever reaching the level needed to provide monetary stimulus to the economy.

In short, even though the Fed may lower its policy interest rate monetary policy may still be tight. And that is exactly how I view the current situation. By failing to prevent the collapse of aggregate demand in late 2008 and having failed to restore it to since then, the Fed has passively tightened monetary policy. This passive tightening of monetary policy is the reason for the sluggish economy and the low interest rates. The financial deleveraging that has Bill Gross so worked up is therefore the result of tight monetary policy, not loose. If Gross really wants to stop the deleveraging then he needs to be calling for something like a nominal GDP level target.

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