Dallas Fed’s Miss On The “Natural Rate”
We’ve been hearing a bit more about the “natural rate” lately. Long time readers here know that Davidson has been covering it on these pages for several years now.
The Dallas Fed recently released the following paper on it:
Yeah, just so incredibly wrong. “Natural Rate” as proposed by Wicksell is to be observed over several economic cycles. The “Natural Rate” is certainly not the very short-term Fed Funds Rate on which this study is focused. The “Natural Rate” comes closer to the 10yr Treasury rate which Greenspan observed in his “Fed Model” of the 1970s, but with Hedge Fund activity and with global capital seeking a safe haven after Russia invaded Ukraine, the 10yr Treasury has been pushed well down from what Wicksell observed.
The “Natural Rate” is the long term (long-long term) rate of growth of society including inflation. It is to be measured across several market cycles. It is meant to be ‘the benchmark’ return against which all other returns can be measured. If all investors understood the concept, the market psychology which leads to excessive pricing would be greatly reduced. Investment bubbles would not occur. Because we include Govt spending in GDP, changes in Govt spending distorts the measurement of GDP. One needs to subtract this spending which is not really a measure of society’s growth. What is left is something on which one can perform a regression to smooth out the economic cycles and get the trend line of growth. Growth in the US has a long-term decline from our measuring point in 1948 because the society has grown 10x in Real terms(inflation adjusted) since 1948. That rate today is 2.97%. This is down from 3.9% level in 1948. The “Natural Rate” is the combined Real Private GDP + 1.8% inflation and today equals 4.77%. The 10yr Treasury rate has best tracked the “Natural Rate” since the inception of the Dallas Fed’s inflation measure, the Trimmed Mean PCE. I use the 12mo Trimmed Mean PCE as the preferred measure of inflation. The 10yr Treasury which Greenspan used in his Fed Model tracked the “Natural Rate” till recent history. Global investors and Hedge Fund activity have driven the 10yr Treasury rate well below the “Natural Rate” seeking safety from market volatility and geopolitical risk.
This Dallas Fed paper is about the Fed controlling rates using the Fed Funds rate. They do not control rates. It is a fallacy which even those at the Fed seem to believe. They raise and lower Fed Funds Rates according to the T-Bill Rates. Their goal is to keep Fed Funds a ‘vig’ above T-Bill rates which are set by market activity.
Doing research on the “Natural Rate” and trying to relate this to Fed Funds is so far away from understanding what Wicksell wrote that it is scary that these folks have PhDs.
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