Waking up Wicksell

I liked March 17 EVA: ‘Fed storm rising’ [Link]. It is lucid, simple and, may be, because I am a votary of the same logic and expectation: that bond yields in the USA are not done
falling, etc.

The EVA report had also suggested reading a WSJ Op.-Ed. by one Mr. Donald Luskin. I did that and, I must confess, I am underwhelmed, at least for two reasons:

(1) Whenever the Fed delays a tightening cycle and has to justify it to their favourite constituency – the stock market – they invoke the Natural Rate of Interest. Ms. Yellen is not the first Fed Chairperson to have done that. Back in the year 2000 or in late 1999, Mr.
Greenspan began a tightening cycle that took the Fed funds rate from 4.75% to 6.5% by mid-2000. He too had ‘woken up’ Knut Wicksell.

(2) As for Mr. Wicksell ‘endorsing’ what the Fed did by keeping rates at zero because inflation was below 2%, Mr. Luskin makes two logical errors in my view. Of course, I do not rule out being wrong myself!

(a) It assumes that zero rate of interest was the natural rate of interest for an inflation rate below 2.0%. What exactly is the rationale for it?

It is one thing to invoke the natural rate of interest argument for marginal changes. It is another thing to say that it provides guidance for the level. It does not. It is still an art and judgemental.

What Mr. Luskin writes about the Taylor’s rule is still relevant for the Wicksellian natural rate of interest, even if somewhat diluted. (b) To anoint the inflation rate as the guiding force for the Federal Funds rate to track the natural rate of interest is nothing new. It is
effectively what most central banks have been following, including the Federal Reserve. But, that has proven to be inadequate. It ignores financial cycles and asset prices about which BIS has been writing eloquently and copiously.

I doubt if Knut Wicksell could have anticipated the extent of the size of financial markets, asset prices and the discourse of the financial markets and their impact on real economy. If he had foreseen them, he would have included them in his determinants of the ‘natural rate of interest’.

Hence, in my view, Mr. Luskin’s proposal is flawed and inadequate and it is only marginally different from what the Fed’s operating model. Therefore, his endorsement of the reappointment of Ms. Yellen that necessarily follows from his flawed recommendation on the natural rate of interest also becomes flawed.


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