Is the Natural Rate of Interest Zero?

The Fed is holding overnight rates at 0% to .25%, and everyone thinks that is some unholy contravening of the natural state of things. The evil central bankers have corrupted the very fabric of the financial system and the free markets. But that line of thinking makes one big assumption that the natural rate of interest is something other than zero.

So what is the natural rate of interest?

I have an economics textbook I used during grad school. It was pretty worthless overall, but it does have a handy glossary. It defines interest as “the payment made for the use of money (of borrowed funds).” We are already off to a bizarre start on our quest to find out what a natural level of interest for the US Federal government is since the US Federal government doesn’t actually borrow money (if this fact confuses you, go here). It spends first and issues bonds second to maintain interest rates at a desired level. Maybe we will just ignore that part and assume that Ben Bernanke does actually show up hat in hand in China from time to time to scrounge up some extra dollars.

That same econ textbook also tells me the interest rate is composed of five parts: the real risk-free interest rate, an inflation premium, a liquidity premium, a default risk premium, and a maturity premium. The real risk-free interest rate doesn’t help us since that is what we are trying to discover. In any case, if you aren’t taking on risk why would you be rewarded with a rate of return greater than zero? It follows then that the real risk-free rate would be zero anyway. Let’s look at the other four components.

Inflation premium: The Fed funds rate is for overnight lending. I sincerely doubt there is much risk of inflation over one night, so it should follow that the inflation premium should be zero.

Liquidity premium: Thinly traded investments that are hard to buy and sell should be more expensive than those that are traded frequently and are easy to trade. In our case the Federal Reserve maintains Fed funds rate by standing ready to buy or sell an unlimited quantity of reserves at a given rate. So liquidity is essentially unlimited. Additionally there are legal requirements for banks to maintain certain levels of reserves (even if there weren’t the mechanics of settling financial transactions demands a certain level of bank reserves as in the case of Canada which has no legal requirement for certain reserve levels). Our liquidity premium should then be zero.

Default risk premium: Since the United States Federal government can create an unlimited amount of dollars and is constitutionally obligated to service its debts, there is no risk of default. The default risk premium should be zero.

Maturity premium: As with the inflation premium we are talking about overnight lending, which is presumably the shortest time period you could lend something. The risk from a sudden change in rates is immaterial since the transaction only lasts one day and would be settled before the rate increase. The maturity premium is therefore zero.

So if we add up the five components we get 0+0+0+0+0=0. So the Fed funds rate should “naturally” be zero.

To those that claim the Fed is holding rates artificially low, I ask why rates should “naturally” be higher. Before you give the classic answer that cheap credit will lead to more private sector debt, inflation, and/or an asset bubble, remember that with interest rates at rock bottom levels the private sector is deleveraging and when rates were higher the private sector was busy taking out the largest loans possible.