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How Central Bankers Manufacture Growth
By messing with interest rates
Interest rates are probably the single most important variable to an economy’s medium term growth. Long term, other factors like education, demographics, and infrastructure matter just as much or more, but it takes decades to feel their impacts. That’s why so much of macro news and discussion focuses on monetary policy and interest rates.
But while it’s fun to discuss and debate how the short term ebb and flow of interest rates impacts stock prices and animal spirits, interest rates do have longer term and more enduring impacts on economies as well.
You often hear talk of this mythical concept called the natural rate of interest. When central bankers move interest rates around, those moves are often measured in terms of how far the actual rate gets moved away from the natural rate. So what’s this natural rate?
The natural rate of interest is the level of interest rates where price levels are stable (neither inflation nor deflation). This definition has evolved a bit over time as policy makers found it preferential to have a bit of inflation (because the debt levels of their countries went up). But generally speaking, the natural rate of interest is the level of interest rates where the economy is neither running too hot nor too cold, in other words the economy is growing at its trend rate.
Trend growth
An associated concept is that of the natural rate of unemployment — similarly it’s the unemployment rate that allows the economy to grow at its trend rate and inflation to be at its target rate. It’s interesting and kind of bleak that economists believe that in its steady state, an economy should have some portion of people that are jobless. The idea is that those jobless people are the labor supply that businesses can use to neutralize the pressure to increase wages when aggregate demand increases. And when demand and the need for labor go down, instead of lowering wages, businesses can dump the excess labor back into the unemployment pool, avoiding deflation. Like I said, pretty bleak.
So why all this talk of natural interest rates and trend growth? It’s because they are closely related. When they’re not being messed with by policy makers, interest…
