It may be frightening to think the central bankers presiding over the global economy are emperors wearing no clothes, but investors who read James Montier’s argument to this effect can perhaps take comfort in the fact that that the investment exec also argues that monetary policy doesn’t matter.
In a new white paper from the famed institutional fund manager GMO called “The Idolatry of Interest Rates,” the iconoclastic investor takes on the wonkish but ubiquitous subject of the “equilibrium real interest rate” (ERIR).
While the subject — also known as the natural rate or neutral rate — can be abstruse, its importance to policymakers cannot be denied.
Former Federal Reserve Board Chairman Ben Bernanke devoted his first blog post to the subject; his successor, Janet Yellen, is said to have mentioned ERIR 25 times in recent speech; and the president of the Federal Reserve Bank of Cleveland called ERIR “the” pressing issue today, Montier recounts.
Economists Larry Summers and Paul Krugman are among the cognoscenti who have weighed in on ERIR, which posits that there is an inherent rate of interest that is consistent with full employment that policymakers can discover in their efforts to set rates correctly.
While eminent people heatedly take different sides on the issue, along comes Montier to ask why no one questions the framework itself. His answer is that the ERIR debate is an example of groupthink stemming from an economic elite of New Keynesians, “many of whom trained at the same university under the same teacher.”
Like medieval churchmen debating how many angels can dance on the head of pin, however, today’s elite fall into the classic trap of making unfounded assumptions.
Montier notes the classic joke of the engineer, chemist and economist stranded on an island with a can of food but no implements. The engineer rigs a contraption that might open the can, the chemist proposes using salt water to erode it and the economist suggests assuming the existence of a can opener.
The GMO exec, on the other hand, shows a chart of wildly swinging short-term rates over the past 60 years and hypothesizes that the rates are reflective of policy decisions rather than market shifts in response to changing capital conditions.
In other words, rates rose steeply in the early 1980s, not because of a scarcity of real capital, but because then-Fed chairman Paul Volcker was determined to break inflation.
Montier also cites recent econometric research that concludes there is little evidentiary support for the idea that trend rate of economic growth drives ERIR, and he presents a table of widely varying estimates (ranging from -5% to +12%) of what ERIR should be.
“Never ones to be deterred by dubious theory, bound by reality, or flinch in the face of impracticality, many economists have engaged in an exercise of estimating a number that might not even exist. The range of estimates that have been generated should alone give pause for reflection,” he writes.
Further pause should stem from the claim by John Williams — one of the leading theoreticians of ERIR and Yellen’s successor as San Francisco Fed president — that “the natural rate of interest is assumed to change over time due to various unobservable influences.”