the making of an economist: The Real Rate of Interest

Knut Wicksell was one of the early economists to propose a 'natural' rate of interest. Early proponents of the Austrian school of economics jumped on this idea and it forms the basis of the Austrian business cycle theory.

Knut Wicksell

Wicksell wrote in his book, Interest and Prices, "There is a certain rate of interest which is neutral to commodity prices, and tends neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital."

Wicksell does not put a number on this natural rate, but merely asserts that it exists. This begs the question, ‘what is the natural rate of interest?’ Frederic Mishkin studied this question by using the familiar Fisher real interest rate equation and applying it. He uses US Treasury notes (which are viewed as ‘riskless’ assets) and subtracting the rate of inflation from them to obtain the real interest rate. His finding was that real interest rates were not constant, which suggests there is not a constant natural interest rate.

Mishkin’s use of US Treasury notes is suspect because, that is a market which has a large amount of government intervention. The preferred channel of US monetary policy is the Federal Funds rate, but in order to set the Federal Funds rate, the Fed uses Treasury notes which are close substitutes (typically 30 day notes). Note Figure 1 to see how closely they parallel each other. Figure 2 shows two different types of interest rates minus inflation, Treasury notes and the average rate for Moody’s AAA corporate bonds. Figure 3 shows the spread between the same two (Moody’s minus Treasury). Figure 2 confirms Mishkin’s idea that the real or natural rate of interest is not constant, but it also provides a hint at how much the Federal Reserve is holding down key interest rates. Figure 3 shows spreads of above 4% happened in the early 1990’s, the early 2000’s, and recently. Figure 2 also shows that real interest rates (even when measured by AAA corporate rates) can go negative as they did in the mid and late 1970’s.

These graphs also show that real interest rates have been trending downward since the early 1980’s. Perhaps it could be said that Treasury notes are substantially less risky than even AAA Corporate bonds. This could certainly be true, but the increasing trend of the spread seems to fly in the face of experience. Are AAA corporations really becoming less likely to repay their debts relative to the US government over a thirty year period? One could just as easily speculate that the opposite is true and that the Federal Reserve is just taking an increasing role within the Treasury market.