Depending on how you calculate it, the natural rate of interest comes in around 3 percent. Given the uncertainty inherent in this type of work, that means somewhere between 2 percent and 4 percent. Note that this is a real rate, so we have to add inflation back in, which gives us a nominal natural interest rate of around 4 percent to 6 percent at the moment, theoretically.
A historical rates comparison
Using the Berra theorem—the well-known economist Yogi Berra’s idea that theory and practice are the same in theory but different in practice—we can then compare this with real historical interest rates to see if it makes empirical sense. The chart below shows the rates paid by inflation-adjusted Treasury bonds.
The general range, of around 2 percent to 3 percent before the financial crisis, supports the economic arguments and the decline during the crisis. Add 2 percent to 3 percent for inflation, and we’re right back to the 4 percent to 6 percent that economic theory suggests. The lower rates during and since the crisis largely appear to be due to a “flight to safety” and central bank actions to flood the markets with money; therefore, they seem less indicative of normal rate levels.
Comparing the natural nominal rate of, say, 5 percent with the current rate of around 2.22 percent for the 10-year Treasury bond tells us that, yes, current rates are well below what they “should” be. The Fed has apparently succeeded in its aim, to lower rates below the natural level, but it’s not quite that simple, which brings us to question 2. We’ll take a closer look at that tomorrow.
Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation’s largest privately held independent broker/dealer-RIA. He is the primary spokesperson for Commonwealth’s investment divisions. This post originally appeared on The Independent Market Observer, a daily blog authored by Brad McMillan.