The Fed and Bernanke Are Wrong About the Natural Interest Rate

by Joseph T. Salerno

A few days before the last FOMC meeting The Wall Street Journal reported on the Fed’s hand wringing over its inability to identify the “natural rate of interest” and explain its recent movements. According to the report, the Fed uses the “mysterious natural rate” to guide its decisions in setting the target for the fed funds rate. Modern macroeconomics defines the natural rate of interest as the (real) rate of interest that maintains the economy in a Keynesian state of bliss, with stable prices (or moderate inflation) and actual real GDP equal to “potential” or full-employment GDP.

According to Fed economists, the natural rate is “unobserved” and therefore “has to be inferred from observable data” using econometric models or other statistical techniques. But different models yield different estimates of the natural rate. These estimates range from “persistently negative since 2008” to a “reasonable range” between 1% and 2%. Nor are these estimates very precise.

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