The Natural Rate of Interest is Zero

This blog can be deemed to follow on from earlier blog, the role of the Central Bank (Federal Reserve).

Why the “natural” interest rate is zero

Modern monetary theorists consider monetary policy to be a poor tool for counter-stabilisation. It is indirect, blunt and relies on uncertain distributional behaviour. It works with a lag if at all and imposes penalties on regions and cohorts that may not be contributing to the price pressures (for example, when Sydney property prices were booming all of regional Australia which was not was forced to bear the higher interest rates). There is also no strong empirical research to tell us about the impact on debtors and creditors and their spending patterns. It is assumed implicitly that borrowers have higher consumption propensities than lenders but that hasn’t been definitively determined.

For a modern monetary theorist, fiscal policy is powerful because it is direct and can create or destroy net financial assets in the non-government sector with certainty. It also does not rely on any distributional assumptions being made.

Further, the natural economic state for a modern monetary theorist is full employment which means less than 2 per cent unemployment, zero hidden unemployment and zero underemployment. Deviations from full employment reflect failed fiscal policy settings – not a large enough budget deficit (other things equal).

The size of deficit has to be judged in terms of the desire of the non-government sector to save in the currency of issue. So if the deficit is inadequate and unemployment arises we know the net spending has not fully covered the spending gap.

We also know that budget deficits add to bank reserves and create system-wide reserve surpluses. The excess reserves then stimulate competition in the interbank market between banks who are seeking better returns than the support rate offered by the central bank. Up until recently this support rate in countries such as Japan and the USA was zero. In Australia it has been 25 basis points below the cash rate although there is no theoretical reason for that setting.

It makes much better sense not to offer a support rate at all. In that situation, net public spending will drive the overnight interest rate to zero because the interbank competition cannot eliminate the system-wide surplus (all their transactions net to zero – no net financial assets are destroyed).

So in pursuit of the “natural” policy goal of full employment, fiscal policy will have the side effect of driving short-term interest rates to zero. It is in that sense that modern monetary theorists conclude that a zero rate is natural. This article by Warren Mosler and Mathew Forstater is useful in this regard.

If the central bank wants a positive short-term interest rate for whatever reason (we do advocate against that) – then it has to either offer a return on excess reserves or drain them via bond sales.

Our preferred position is a natural rate of zero and no bond sales. Then allow fiscal policy to make all the adjustments. It is much cleaner that way.

Bill Mitchell


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