Near-zero interest rates can go lower — the question is, should they?

Today, even as inflation unexpectedly surges, Federal Open Market Committee (FOMC) members plan to keep interest rates near zero through at least 2022. The committee believes that current price pressures will moderate and inflation will return to the Federal Reserve’s 2-percent target without any substantial increase in the Federal Funds rate. The Fed’s current reaction to inflation is strikingly different from its responses during the “Great Moderation.” In that era, the Fed would have raised policy rates to preemptively quash inflation. What changed the Fed’s thinking? Could the new approach backfire?

Over the past decade, the Fed and other major central banks have come to believe that ultra-low interest rates are a consequence of changes in the global economy and not the Fed or other central banks’ policies. The narrative linking ultra-low interest rates to structural features of the global economy evolved as interest rates in major developed economies hovered near or below zero for longer than most economists imagined possible.

The idea that ultra-low interest rates are driven by structural changes in the economy, and not by monetary policy, is consistent with influential economic conjectures that the global economy is experiencing “secular stagnation,” or a condition wherein global savings is consistently greater than new profitable investments. With underinvestment in new plant, equipment and information technologies, economies have continually operated below their full-employment potential. 

Secular stagnation is purportedly caused by demographic changes like an aging workforce and stagnant or declining labor participation rates. Other causal factors include technological changes that reduce the real cost of capital investments, excess emerging country savings, and an increased appetite for safe investments like U.S. Treasury securities. Secular stagnation is claimed to explain many features of the past decade including low interest rates, persistently high unemployment, slow productivity growth and asset price inflation caused by excess saving chasing existing real and financial assets.

Certain types of demand are sensitive to the real rate of interest — the observed nominal interest rate less the expected rate of inflation. Among these are investments in long-lived plant and equipment, information technology, housing and consumer durables. If the economy is operating below its perceived potential with unemployment higher than desired, central banks typically adopt policies that attempt to stimulate interest-sensitive demand by lowering the real interest rate.

Nominal short-term interest rates are set by central bank monetary policy and have been close to zero in the U.S. or slightly negative in Europe for the past decade. Prior to central bank quantitative easing programs, longer-term real interest rates were set by financial markets. With nominal interest rates essentially zero, real rates of interest can only be reduced by forcing nominal interest rates (more) negative, or by increasing the expected rate of inflation. 

When persistently ultra-low interest rates did not stimulate the economy to its full-employment potential, economists began to focus on a new theoretical construct, the long-run equilibrium full- employment real interest rate or R-star. R-star is not an observable interest rate. It is the theoretical rate that will neither stimulate or retard economic growth when the economy is operating at full employment. It can only be estimated indirectly using sophisticated statistical models that produce estimates with wide confidence bands. Estimates of R-star by economists, including some at the Fed, suggest that R-star has been falling for decades and is now somewhere between 0 and – 2 percent.

With nominal interest rates close to zero in the U.S. and slightly negative in Europe, there is significant debate regarding the benefits of pushing nominal rates even lower. The simulative effects of negative nominal rates are unproven while the impact of negative rates on the long-run viability of banks, life-insurance and other financial institutions is beyond debate. With nominal rates stuck near zero, central banks have been trying to lower the real interest rate through inflation expectations by adopting “flexible average inflation targeting” and expanding the monetary base with massive quantitative easing purchases.

If R-star is indeed as low as -2 percent and inflationary pressures prove more durable than the FOMC anticipates, it should take only modest increases in the nominal interest rate to significantly raise the real rate of interest, moderate interest-sensitive demand and keep investors’ inflation expectations anchored around the FOMC’s 2-percent long-run target. The idea that R-star is negative suggests that any unexpected inflation can be controlled with only modest increases in the nominal interest rate. This is especially important given the impact nominal interest rates have on the already bloated Federal budget deficit.    

The theory that central bank policy rates are stuck near zero because of secular stagnation and a negative R-star is a new and unproven conjecture. But it does help to explain why the Fed seems complacent about the current surge in inflation. If R-star is negative, the risk of accelerating inflation seems remote. But like so many economic theories, if R-star turns out to be nothing more than rampant economist groupthink rationalizing the failure of past central bank policies, the outlook for inflation may not be so sanguine. 

Paul H. Kupiec is a resident scholar at the American Enterprise Institute (AEI), where he studies systemic risk and the management and regulations of banks and financial markets.