Bianca De Paoli and Pawel Zabczyk
One way to assess the stance of monetary policy is to assert that there is a natural interest rate (NIR), defined as the rate consistent with output being at its potential. Broadly speaking, monetary policy can be seen as expansionary if the policy rate is below the NIR with the gap between the rates measuring the extent of the policy stimulus. Of course, there are many challenges in defining and measuring the NIR, with various factors driving its value over time. A key factor that needs to be considered is the effect of uncertainty and risk aversion on households’ savings decisions. Households’ tolerance for risk tends to be lower during downturns, putting upward pressure on precautionary savings, and thereby downward pressure on the natural interest rate. In addition, uncertainty dictates how much precautionary savings responds to changes in risk aversion. So policymakers need to be aware that rate moves to offset adverse economic conditions that are appropriate in tranquil times may not be sufficient in times of high uncertainty.
As nicely explained in an FRBSF Economic Letter, the NIR is unobservable, but can be tracked with a model that identifies the interest rate that would prevail when output is at its potential—or, absent cost shocks, at a level consistent with stable inflation. In a recent article, we describe the determinants of the natural rate of interest in a fairly standard economic model of the so-called New Keynesian (NK) variety. Our simple setup clearly doesn’t account for all factors driving the natural rate. For example, the closed-economy nature of the model excludes the possibility that global factors such as reserve purchases by foreign central banks or a significant increase in the global supply of savings could be pushing down the equilibrium interest rate. But our model does account for uncertainty and precautionary savings motives. The importance of both of these factors has been apparent during the recent recession, and both are typically ignored in the textbook NK model. Considering the ability of changes in risk aversion and uncertainty to affect the transmission mechanism of shocks and monetary policy allows our setup to clarify how these considerations affect the natural interest rate.
In the standard NK model, the long-run natural interest rate is pinned down by the potential growth rate of the economy and the rate at which agents discount the future. In the medium run, expectations of lower growth can push down the NIR temporarily. Tighter fiscal policy or changes in people’s discount preferences are additional reasons for the NIR to drop.
But factors related to risk are also potentially important, and, in the recent recession may have significantly depressed the natural rate of interest. A recent IMF paper finds that two-fifths of the sharp increase in household saving rates between 2007 and 2009 can be attributed to the precautionary savings motive. An increase in precautionary savings is consistent with a lower natural interest rate.
Theoretically, changes in precautionary savings can come about via sudden changes in macroeconomic uncertainty (or volatility) as well as sudden changes in agents’ tolerance for risk. Precautionary behavior can also be a cyclical phenomenon. Using a model built to match risk premium dynamics, we find that agents are more risk averse during downturns than they are in upturns. This will be the case particularly if shocks to economic conditions are persistent and consumers take a long time to get used to new conditions. So, even if a change in risk appetite is not the source of the economic downturn, the downturn itself may propagate as agents become more cautious in their consumption decisions. And this risk aversion propagation mechanism can be significant during unusually volatile or uncertain times and depress the natural interest rate for a long period of time.
What then is the policy implication of this insight? We argue that accounting for a cyclical change in precautionary savings points to a more accommodative stance during downturns by lowering the NIR. As negative shocks to demand are magnified by an increase in precautionary behavior, a larger policy rate response is required to curb deflationary pressures. Even negative supply shocks—which are generally inflationary—may be less so if they motivate people to save more for precautionary reasons. Accordingly, the policy rate that is consistent with stable prices ends up being lower when one takes into account that risk aversion falls during downturns.
By the same reasoning, this risk aversion propagation mechanism implies that the policy rate should be higher in boom periods when risk aversion is lower. To the extent that positive demand and supply shocks are relatively more inflationary if accompanied by a decrease in risk aversion, monetary policy needs to respond to these shocks more aggressively.
Policymakers should also be aware that changes in the NIR driven by precautionary savings are more dramatic in volatile times. And the arguments made here for the NIR hold for other approaches to measuring monetary policy. Namely, volatility needs to be accounted for when designing monetary policy rules as policy responses that are appropriate in relatively tranquil times may not be sufficient in times of high uncertainty.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Bank of England, the Federal Reserve Bank of New York, or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
Pawel Zabczyk is an adviser at the Centre for Central Banking Studies at the Bank of England.