Interest rates their models and interest rate policy

The natural rate of interest and its determination, especially with respect to when and how the Fed and other world central banks should raise interest rates, is a hotly debated topic.  Many suggest that the only way to get back to trend GDP growth is to push interest rates below ZERO, into negative space, and/or to raise inflationary expectations.

The trouble, as I see it, is that the models used to determine the natural rate, or what the current policy rate should be, focus almost entirely on equilibrium concepts and a restricted set of difficult to define inputs, and can therefore miss key turning points in the domestic and global economic frame.   These are after all, in most cases, simple rule of thumb models. 

From a brief consideration of the subject and given my own historical stance with regard to key developing structural imbalances, I have the following simple propositions on the natural rate/negative interest rate debate

  • Natural Interest Rate models ignore accumulated financial and structural economic imbalances, imbalances that are also likely occasioned and accentuated by transitions and policy responses to those transitions.  Importantly the build up phase (excess) can raise growth (note US consumer debt/consumption expenditure) and mask changes in trend, while the build up itself can serve to push growth lower post crystallisation.  Additionally, point in time models are insensitive to the impact of the power of compound errors: policy that miss changes in trend and accommodate divergence from trend can last as know some time.
  • At critical turning points IR policy may ignore transitions and accumulating imbalances and risks creating significant divergences between the financial and the economic that collapse back through the core financial system as we saw in 2008/2009.  In this case, a deceleration in growth may be viewed as a below trend growth phase (for whatever reason) with policy lowering rates: note the increase in debt and debt relative to income and GDP growth in recent times.   Outsize increases in debt due to lax monetary policy may also impact global structure.
  • The financial and economic shocks that arise from this insensitive IR policy feed back into GDP and key relationships with negative consequences.   Imbalances are accentuated and transition dynamics ignored.  For example a transition to lower growth due to issues of frame may end resulting in a crisis of frame.  
  • The big question is how does IR policy fit into the big picture when we have transitions and accumulating structural economic and financial imbalances not captured by models?  Which problem do we deal with, since we now have more than 1?

In a world of many transitions and imbalances there may be more than one interest rate: one to accommodate financial imbalances and preventing their adjustment in a lower growth frame; another to offset some of the many negative trends impacting growth (thereby risking further financial and structural economic imbalances); another that would better reflect the balance of factors in emergent growth dynamics of a given frame once imbalances had adjusted and transitions completed.   A lower IR is needed for the first 2, a higher for the latter.  Of course, at the moment, our tool box only affords room for one interest rate, so who are you going to throw to the dogs?  I guess the objective is to keep all rates aligned as close to each other as possible and to minimise intervention.

If we ignore imbalances and transitions and assume that deviations from a given trend growth in output are all temporary and due to excess of saving over investment and not any other argument, then we risk more of the same.   Accumulated monetary policy errors weigh on time and are not necessarily washed out by time.