Monthly Archives: April 2015

The Consequential Saving-Investment Gap

Now that he’s retired from his eight-year stint as chairman of the Federal Reserve, Ben Bernanke is working as a “Distinguished Fellow” at the Brookings Institution, and has recently started his own blog on their website. Regardless of what you may think about monetary policy under his tenure as Fed chairman (I know I have my reservations), his recent post, “Why are interest rates so low?” does clear up some common misconceptions about interest rates and the interpretation thereof relevant to the stance of monetary policy. Here’s Bernanke:

If you asked the person in the street, “Why are interest rates so low?”, he or she would likely answer that the Fed is keeping them low. That’s true only in a very narrow sense. The Fed does…set the benchmark nominal short-term interest rate. The Fed’s policies are also the primary determinant of inflation…and inflation trends affect interest rates…The Fed’s ability to affect real [inflation-adjusted] rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth—not by the Fed.

To understand why this is so, it helps to introduce the concept of the equilibrium [Wicksellian] real interest rate…the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments. In a slowly growing or recessionary economy, the equilibrium real rate is likely to be low, since investment opportunities are limited and relatively unprofitable. Government spending and taxation policies also affect the equilibrium real rate…because government borrowing diverts savings away from private investment.

If the Fed wants to see full employment of capital and labor resources…its task amounts to…push[ing] those rates toward levels consistent with…its best estimate of the equilibrium rate…If the Fed were to try to keep market rates persistently too high, relative to the equilibrium rate, the economy would slow (perhaps falling into recession), because capital investments (and other long-lived purchases, like consumer durables) are unattractive when the cost of borrowing set by the Fed exceeds the potential return on those investments. Similarly, if the Fed were to push market rates too low…the economy would eventually overheat, leading to inflation…The bottom line is that the state of the economy…ultimately determines the real rate of return attainable by savers and investors. The Fed influences market rates but not in an unconstrained way…

This sounds very textbook-y, but failure to understand this point has led to some confused critiques of Fed policy.

Exactly right. When we casually examine where the Fed has set interest rates over time, it’s important to recognize that the Fed does not set these rates in a vacuum. The optimal interest rate is not one that necessarily remains steady over time, but can and does fluctuate based on economic conditions. In a weaker economy, lower investment demand and an elevated propensity to save can naturally be expected to lower the equilibrium interest rate. But because the Fed targets a key interest rate—the federal funds rate, an overnight interbank lending rate—to mediate its provision of the monetary base, it must make deliberate adjustments to its own interest rate target. Given that the Fed has control over the monetary base, it must influence short-term interest rates one way or another. It does not make much conceptual sense for an extant Fed to “do nothing” when, by its very existence, it is doing something to the monetary base (and, by proximity, interest rates) even if that means not changing it at all. (It wouldn’t make sense for a state-run oil monopoly with market power to “do nothing” with respect to oil prices in its market, would it?)

This means that as the Fed targets a lower and lower interest rate during a recession, it is not necessarily the case that the Fed is pushing interest rates too low. Interest rates could be too low, too high, or just right, but we should expect them to fall in that situation. (And vice versa for raising interest rates in a recovering economy.) Now, the fact that the Fed has to make certain adjustments may suggest that it has previously erred with respect to its interest rate decisions and is playing catch-up (for instance, by leaving interest rates too low and then hiking them swiftly to belatedly fight off inflation). But the bottom line is that just because the nominal interest rate is historically low, or even zero, does not necessarily mean that the real interest rate is too low relative to the equilibrium/natural/Wicksellian interest rate.

In fact, estimations of this rate have suggested that during recent years, interest rates should have gone even lower, despite being at zero. But how could it be so low? In one interpretation, the natural rate of interest is that which equilibrates real savings, or underconsumption, with real investment. And consider that as a result of the recession, net private savings surged while net (domestic) investment fell, prompting the considerable saving-investment gap seen on the right:


This notion, loosely illustrated above, has important implications for Fed policy. The tendency of people (in reality, mostly firms) to increase money balances by sequestering more income as uninvested savings will, left unchecked, contract spending (and, by identity, income), which will in turn contract real output given the nominal rigidities which are undoubtedly present in the economy. And given the elevated propensity to build money reserves amidst the uncertainty in the wake of the financial crisis and a struggling economy, the Fed should accommodate such balance sheet deleveraging by expanding the monetary base.

And it has, dramatically. But at the zero lower bound, there is difficulty in making these efforts fully efficacious because nominal rates cannot go lower to deter excessive saving and encourage investment. That is why some argue that price inflation should have gone higher during the recovery to push real interest rates lower and support this process–of course, until the stronger economy raises the equilibrium rate back up again. (If that sounds too artificial, just interpret it as compensating for the lower inflation that was experienced due to the recession.)

Because ultimately, it is this saving-investment relation which is the harbinger of most economic fluctuations. Just consider its close correspondence to the gap between realized and potential GDP:


Now, contingent on how exactly the CBO estimates potential GDP, I should caution that its calculation could possibly produce some dependency by construction (I’m not familiar enough to be sure). Notwithstanding that, if there was ever any doubt that business cycles are largely a monetary phenomenon, this should clear it up.

In my view, Bernanke’s interpretation of current low interest rates likely gives too much weight to a long-term trend of excess global savings, as his follow-up post suggests. His chart of interest rates on 10-year Treasury bonds juxtaposed with CPI inflation omits the reduction in the risk of inflation, etc. which rise with duration, i.e. the “term premium” (more on that here). (Update: Bernanke added a new post on the term premium.) But with respect to the recent situation (which is improving–the economy made solid gains in 2014), the point saliently stands. Improving our understanding of just how important the saving-investment relationship is could surely serve, through the opinions of those who circumscribe monetary policy, as a benefactor of greater economic stability.