Essay About Natural Long-Term Rate And Federal Funds Rates Of U.S.

Comment on the Article “a Natural Long-Term Rate”
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Name：Professor Name：Course Code：Date:Comment on the Article “A natural long-term rate”1. IntroductionIn 2013, The Economist published an article with the title of “A natural long-term rate”. This article, by analyzing the latest economic projections on federal funds rates of U.S. and real policy rates of U.S. and other countries, has discussed the relationship among natural rate, financial rate and policy rate by adopting theories regarding natural rate of mainstream economists and proposed two main viewpoints: 1) there are two main reasons contributing to the low natural rate of U.S., namely sluggish investment and saving glut; 2) policy rate, though is controlled by Federal Reserve to stay a low level, if were to go down further, demands and investment in U.S will suffer a decline and U.S. will maintain a low real rate for a longer period (The economist). This paper then is to verify and analyze the viewpoints in this article. 2. Discussion 2.1. Sluggish Investment and Saving GlutThe current sluggish investment and saving glut in U.S. is closely relevant to the quantitative easing policies implemented successively after the outbreak of financial crisis of 2008. Quantitative easing policies are expected to encourage people to borrow money and spend money, reduce unemployment rate and facilitate recovery from a prolonged weak economic growth. Certain efforts are achieved in general, including the growing investment in some sectors, increasing expenditure in consumer durables and rising stock price in stock market. However, real estate still has a slow recovery, investment in construction remains weak, growth of wages declines and unemployment rate remains relatively high. The lack of confidence in prospects of economic growth makes it harder to expand personal consumption expenditure rapidly. Meanwhile, the personal saving rate is on a rise (see Figure 1). In addition, Quantitative Easing policies will enlarge national debts, downgrade government credit and increase risks of investment, which in turn, all contribute to the lack of confidence in investment and even the sluggish investment. Thus, quantitative easing policies can increase liquidity of financial markets on the one hand and will result in sluggish investment and saving glut objectively on the other hand (Olivier and Milesi-Ferretti, 17-19). Then why sluggish investment and saving glut will cause low natural rate? Knut Wicksell held that “natural rate refers to the real rate required by the achievement of ideal resource allocation (demands and supplies are equal for all commodities). When interest rate falls below natural rate, economy will grow and commodity price will rise concurrently. When interest rate is above natural rate, economy will shrink and commodity price will drop concurrently (107). Wicksell did not clearly point out what kind of rate the natural rate is and only defined it as the rate used in physical credit. At present many economists deem it as the marginal productivity of capital or expected rate of return, namely the equilibriuminterest rate with balance between supply of savings and demand for investments (Shostak, 2). Therefore, such natural rate is closely relevant to the real rate.

With high saving rate, investment is to decrease and a downturn in economy is to occur. Thus, all central banks may need to adopt many unconventional means (QE is gradually losing effectiveness) to lower real rate, stimulate investment and reduce savings (Fama and Schwert, 115). For example, inflation target can be raised, if reliable. That is to say, by raising inflation rate, nominal rate, restricted by savings and investment trends, will be controlled at a low level for a long period, hereby reducing the real rate (deducting inflation from nominal rate). Thus, sluggish investment and saving glut will further result in the lowering of natural rate.  2.2. Low Real rateFederal Reserve can impact the real rate of return, especially the long-term real rate in an indirect way. “Why are interest rates so low”? Some people may deem that the low rate is controlled by Federal Reserve. In the narrow sense, it is indeed the Federal Reserve who is determining the short-term Federal Funds rate, whose decision will also impact long-term inflation and inflation expectations. However, real rate or interest rate adjusted for inflation (deducting inflation from market rate or nominal rate) is most essential to economy. Real rate can exert material impact on decisions related to capital while Federal Reserve only exerts limited impact on market rate (Petroff). Other countries in the world, not just U.S., all have an extremely low short-term and long-term interest rate. For example, in the first half of 2015, 10-year Treasury Bill rate reached 0.2% in Germany, 0.3% in Japan and 1.6% in UK while maintained negative in Switzerland. Meanwhile, loan rate for enterprises and individuals are just a little higher (Bernanke). Such a low real rate is the results from the sluggish investment and saving glut as mentioned above as well as the low federal funds rate determined by Federal Reserve. Federal Reserve mainly relies on the economic trend of U.S. to make decisions on its interest rate. Generally, Federal Reserve has two policy goals, namely maintaining price stability and promoting employment. Federal Reserve, if it were to expect a weaker economy and downward spiral of commodity price, will adopt an easier monetary policy like cutting interest rate. Under the opposite conditions, Federal Reserve then will adopt policies like raising interest rate to tighten up monetary policy (Meltzer 361). However, the true situation lies in as following: firstly, U.S. suffered a severe economic recession from the end of 2007 to the middle period of 2009 (see Figure 2). Its GDP fell down to a lower level since the end of 2007 and had a modest rebound at the middle period of 2009; secondly, with the sharp decline in economy, unemployment rate of U.S. peaked at 10% in October 2009 and later gradually fell down, maintaining a high level prior to 2013 (see Figure 3); thirdly, along with the wave of job cuts, real estate market was stuck in the doldrums. Millions of people could not afford the mortgage house loans and the mortgage rate dropped and maintained a low level after the bursting of house bubbles. Thus, to recover the U.S. economy, Federal Reserve started the interest rate cut in 2007 and continued the interest rate cut later. This is due to that if federal funds rate is at a high level and market rate is higher than equilibriuminterest rate, then the costs of loans will be higher than returns, resulting in the loss of attraction for capital investment (as well as other permanent consumption, such as consumption of consumer durables) and sluggish economic development (Bech and Klee 415). Federal funds rate bottomed in 2009 and was kept at the same level by bankers till the first increase of 0.25% in October 2015 (see Figure 5).