Professor Richard Werner did a seminal study when he was at the BOE that discovered empirically, that higher nominal rates were positively correlated with economic growth. I'm no expert, but the argument goes something like rates are reflected in the term structure of prices. Thus, low rates or ZIRP flattens the term structure thereby disentivizing investment bringing both productivity and inflation down with it. I'd be very curious to see what very slow and steady rate hikes would do the economy over time. I think as they filter through the economy, the economy could absorb them. However, in modern times there's this desire to "normalize" rates and we go from ZIRP to 2.5% in 12 months and then back down. The speed seems to be very disruptive. Just my 2 cents. What do u think Alf? And keep up the great work. 👍
Feb 15, 2022·edited Feb 16, 2022Liked by Alfonso Peccatiello (Alf)
Excellent article as usual Alf! I do have a few things to add however.
This notion of "the stars" that you allude to (r*, u* or natural rate of unemployment or NAIRU, p* or potential GDP%) are indeed favored by central bank academics and are key econometric parameters in their DSGE or Dynamic Stochastic General Equilibrium models and on their close cousins (HANK models or Heterogenous Agent Neo-Keynesian models).
The problem is that the macro-economy is empirically NOT an equilibrium system that can be described by partial or full equilibrium analysis (despite what your econ 101 textbooks claim, the world does not do straight lines)
The macro economy and financial markets are actually complex adaptive dynamic systems (not equilibrium systems whether stochastic or not, dynamic or not).
DSGE and HANK models are empirically not true just like the EMH but their mathematics are indeed much more comprehensible, elegant and easier for our monkey brain to grasp and that's why they remain favored by central bank academics (most of which have their academic reputation riding on DSGE models and as we all know "science advances one funeral at a time")
The "stars" in a complex adaptive dynamic system are indeed non-observable variables as you correctly point out in the article which is one of the reasons why central bankers who are supposed to know everything about everything never see a recession coming or a shock in the financial or real economy..."our models say that subprime is contained", "QT will be like watching paint dry", "no reason for concern in the commercial paper market", "inflation will be transitory".
If modern physicists, chemists or biologists had their track record I would question my faith in humanity and in the scientific enterprise but thankfully our colleagues in the hard sciences got our back!
As far as long run and REALLY long run real rates and real return on assets there's a variety of other metrics and evidence that shows exactly what you would expect which is positive long run real rates although certainly less positive than in the past and declining (which sucks for us!). But yes, long run real rates and long run real return on assets as a time series is statistically co-integrated with demographics and productivity growth (just like real exchange rates between any two currency pairs are co-integrated vis-a-vis real rate differentials but I would NOT go taking a position on that as those long run relationships mean NOTHING for your short run results where short run is not the 5min chart, the daily chart or even the monthly or even quarterly chart!)
As far as inflation expectations and the "expectations channel" goes, I would suggest going over Jeremy Rudd recent paper. It is very technical of course but worth the read
For those interested I would strongly suggest becoming familiar with the work of the complexity theory group at the Santa Fe institute as well as the work of professor Andrew Lo at MIT (Adaptive Markets Hypothesis), the work by professor Stephen Keen and professor Didier Sornette at the Swiss Federal Institute of Technology among others.
I think professor Keen's book titled Debunking Economics is a must for all macro traders and analysts that want to bring their econometric modeling into this century and embrace what complexity theory has to offer to our understanding of markets and complex adaptive dynamic social systems (as opposed to complex adaptive dynamic PHYSICAL systems like the weather or a block of enriched uranium)
Professor Lo's book is also a must!
Finally, let me say that even though DSGE/HANK models, partial and full equilibrium analysis is indeed empirically junk science let us not forget that "all models are wrong, some models are useful and some models are dangerous"
Another good person to set a chat up with is Lyn Alden. She’s concerned about the credit system as well, very defensive right now, but has a long term inflationary stance. Would be interesting to see the contrast in medium term outlook between you two (Fed u-turn timing). She’s right up there at the top with Snyder on market/macro intelligence in my opinion.
So what happens when we get to the point where cant lower interest rates anymore? We aren't there yet because we have (theoretically) room to tighten as projected over the next year. But eventually we will hit absolute zero and will never be able to raise again (if we aren't there already). What happens then?
Wonderful piece! But I'm really curious how equilibrium r* is found from data. A piece about it would be great. Thanks Alf for another inspiring piece.
The cost to transition from carbon to renewables is going to be unlike anything mankind has encountered. Sure we have carbon credits and ESG investing but to ignore it's (climate change) impact while focusing on productivity and net population growth is leaving out what might be the most important variable of all.
Wonderful post. Thanks for writing it. I have two questions:
- Can you please give me the reference of the paper of the BoE from which you excerpted the chart of the 700 years of history of real interest rates? I had heard about that publication but I have not been able to find it.
- As output is a function of labor and capital, with decreasing labour productivity and labor participations rates, is there any chance lower labour can be offset with higher capital accumulation? Would marginal capital return start diminishing?
You and Jeff Snider good pals? You guys should do a one on one soon... He's right up your alley or are you on his? Good piece!
Professor Richard Werner did a seminal study when he was at the BOE that discovered empirically, that higher nominal rates were positively correlated with economic growth. I'm no expert, but the argument goes something like rates are reflected in the term structure of prices. Thus, low rates or ZIRP flattens the term structure thereby disentivizing investment bringing both productivity and inflation down with it. I'd be very curious to see what very slow and steady rate hikes would do the economy over time. I think as they filter through the economy, the economy could absorb them. However, in modern times there's this desire to "normalize" rates and we go from ZIRP to 2.5% in 12 months and then back down. The speed seems to be very disruptive. Just my 2 cents. What do u think Alf? And keep up the great work. 👍
Excellent article as usual Alf! I do have a few things to add however.
This notion of "the stars" that you allude to (r*, u* or natural rate of unemployment or NAIRU, p* or potential GDP%) are indeed favored by central bank academics and are key econometric parameters in their DSGE or Dynamic Stochastic General Equilibrium models and on their close cousins (HANK models or Heterogenous Agent Neo-Keynesian models).
The problem is that the macro-economy is empirically NOT an equilibrium system that can be described by partial or full equilibrium analysis (despite what your econ 101 textbooks claim, the world does not do straight lines)
The macro economy and financial markets are actually complex adaptive dynamic systems (not equilibrium systems whether stochastic or not, dynamic or not).
DSGE and HANK models are empirically not true just like the EMH but their mathematics are indeed much more comprehensible, elegant and easier for our monkey brain to grasp and that's why they remain favored by central bank academics (most of which have their academic reputation riding on DSGE models and as we all know "science advances one funeral at a time")
The "stars" in a complex adaptive dynamic system are indeed non-observable variables as you correctly point out in the article which is one of the reasons why central bankers who are supposed to know everything about everything never see a recession coming or a shock in the financial or real economy..."our models say that subprime is contained", "QT will be like watching paint dry", "no reason for concern in the commercial paper market", "inflation will be transitory".
If modern physicists, chemists or biologists had their track record I would question my faith in humanity and in the scientific enterprise but thankfully our colleagues in the hard sciences got our back!
As far as long run and REALLY long run real rates and real return on assets there's a variety of other metrics and evidence that shows exactly what you would expect which is positive long run real rates although certainly less positive than in the past and declining (which sucks for us!). But yes, long run real rates and long run real return on assets as a time series is statistically co-integrated with demographics and productivity growth (just like real exchange rates between any two currency pairs are co-integrated vis-a-vis real rate differentials but I would NOT go taking a position on that as those long run relationships mean NOTHING for your short run results where short run is not the 5min chart, the daily chart or even the monthly or even quarterly chart!)
As far as inflation expectations and the "expectations channel" goes, I would suggest going over Jeremy Rudd recent paper. It is very technical of course but worth the read
https://www.federalreserve.gov/econres/feds/why-do-we-think-that-inflation-expectations-matter-for-Inflation-and-should-we.htm
For those interested I would strongly suggest becoming familiar with the work of the complexity theory group at the Santa Fe institute as well as the work of professor Andrew Lo at MIT (Adaptive Markets Hypothesis), the work by professor Stephen Keen and professor Didier Sornette at the Swiss Federal Institute of Technology among others.
I think professor Keen's book titled Debunking Economics is a must for all macro traders and analysts that want to bring their econometric modeling into this century and embrace what complexity theory has to offer to our understanding of markets and complex adaptive dynamic social systems (as opposed to complex adaptive dynamic PHYSICAL systems like the weather or a block of enriched uranium)
Professor Lo's book is also a must!
Finally, let me say that even though DSGE/HANK models, partial and full equilibrium analysis is indeed empirically junk science let us not forget that "all models are wrong, some models are useful and some models are dangerous"
Another good person to set a chat up with is Lyn Alden. She’s concerned about the credit system as well, very defensive right now, but has a long term inflationary stance. Would be interesting to see the contrast in medium term outlook between you two (Fed u-turn timing). She’s right up there at the top with Snyder on market/macro intelligence in my opinion.
So what happens when we get to the point where cant lower interest rates anymore? We aren't there yet because we have (theoretically) room to tighten as projected over the next year. But eventually we will hit absolute zero and will never be able to raise again (if we aren't there already). What happens then?
Hi Mr. Alf, does the Federal Reserve publish their estimate of R*?
Wow a 5 minute masterclass! Thanks Alf, that's blown the cobwebs out this afternoon.
Wonderful piece! But I'm really curious how equilibrium r* is found from data. A piece about it would be great. Thanks Alf for another inspiring piece.
How does one calculate R* please?
The cost to transition from carbon to renewables is going to be unlike anything mankind has encountered. Sure we have carbon credits and ESG investing but to ignore it's (climate change) impact while focusing on productivity and net population growth is leaving out what might be the most important variable of all.
Great article Alf!
Dear Alfonso,
Wonderful post. Thanks for writing it. I have two questions:
- Can you please give me the reference of the paper of the BoE from which you excerpted the chart of the 700 years of history of real interest rates? I had heard about that publication but I have not been able to find it.
- As output is a function of labor and capital, with decreasing labour productivity and labor participations rates, is there any chance lower labour can be offset with higher capital accumulation? Would marginal capital return start diminishing?
Thank you very mich
Best regards
Javier
Veryood article Alf! Thanks. @lucasmaruri
Can these framework be applied to emerging economies?
Thank you Alf!
What is your estimate of r* for the euro zone?
Enjoyed the comment! thank you