Why the Price of Money Surged in the Last Six Years

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1:55Hello and welcome to another episode of the All Thoughts podcast. I'm Tracey Allaway. And I'm Joe Weisenthal. Joe. Yeah. Yes. Recently, Stephen Myron, who is chair of the Council of Economic Advisors and also the newly confirmed Fed board member. Yeah. He made his first public speech since joining the central bank. And you know what it was about? I do. But go on. The neutral rate. The natural rate of interest. Our star. Yes. basically all about our star, which is like pretty significant for his first speech. I mean, to me, this has come up on a bunch of episodes lately. To me, this is the multi trillion dollar question, which is we're according to September 24th, 2025.

2:37Why are long term rates so much higher? Why does the market perceive that rates will have to be so much higher in order for the Fed to hit its inflation goals than the market perceived in 2019? What changed in the last six years or five years or whatever? Well, also, I mean, our star has always been something of a controversial idea and people criticize it for being this unobservable thing. And, you know, it's a hypothetical estimate that's extracted from all this different stuff like savings and spending and productivity and demographics, investment. You can go on and on and on. Climate, immigration.

3:12Yeah, exactly. But I think, you know, our star is probably going to get even more controversial or perhaps more under the spotlight is a way of putting it, given that people like Myron in his speech where he was arguing that the natural rate of interest should be zero right now, which is very, very different than other sort of normal estimates out there, which has the natural rate of interest at like 3.3 or 3.9 percent, something like that. And so if you think the neutral rate of interest is a lot lower, then you would assume that the Fed should be loosening more. And conversely, if you think R star is high, which a lot of people have argued in recent years, then you would argue that interest rates don't look that restrictive at the moment.

4:00So we should clearly talk more about this. And we've actually never done a specific episode just on the neutral rate. So I'll just say two things. I'm probably something of an R-star truther in the specific sense that I doubt, like, okay, everyone agrees it's like, quote, unobservable, etc. But I doubt that there is actually some rate that will magically bring the economy into balance if we knew what it was. That doesn't mean I don't find this to be a conceptually useful conversation. And yet you don't believe in the term premium. I don't really believe in any of this stuff. No, that's not true.

4:33I am very interested in setting aside whether something could theoretically be observed, whether one number could bring everything into balance, all of these things, setting aside that question. Something has changed in the underlying economy. If you want to call that a neutral rate of interest, I guess I'm totally fine with that. But something's changed and I want to know what it is. But more importantly, I want to know why. All right. Well, we have the perfect guess. We're going to be speaking with Tom Orlick, who is, of course, chief economist at Bloomberg Economics. He's been on a number of times before.

5:04And Jamie Rush, director of global economics at Bloomberg Economics. And together with Stephanie Flanders, who is the head of Bloomberg Economics and also the host of the Trumponomics podcast, have written a book all about the neutral rate of interest. A whole book about it. Yeah. Called The Price of Money, A Guide to the Past, Present and Future of the Natural Rate of Interest. Amazing. I'm really excited. So let's get started. Tom and Jamie, thank you so much for coming on All Thoughts. Great to be here. Thanks, Tracy. Thanks, Jay. Thanks for having us. First of all, congratulations on the new book.

5:40And I got to say, it's kind of ballsy to tackle this concept that a lot of people don't believe in, excluding Joe. And, you know, that tends to generate a lot of criticism. And maybe it's even ballsier to publish your own model so that everyone can see what the estimates actually are. I mean that as a genuine compliment, but why a book on the neutral rate? What prompted it? So I actually recall a tweet from Joe a while ago where he took aim at books as a concept. Oh, yeah. So not only do I not believe in R-Star or anything, I don't even believe in the premise of book. No, I do believe in the premise of book.

6:16No, Joe believes all books should be a tweet. That's right. Keep going. Exactly. So we've written about a concept Joe doesn't believe in, in a format that Joe doesn't support. So we feel incredibly lucky to be on the podcast. So why now? I think there's a couple of ways to answer that question. The first is, I mean, this is really important, right? We talk about the neutral rate of interest, but really a different way of saying it is it's the cost of borrowing in the economy, right? And the cost of borrowing is incredibly consequential for ministers of finance. It's incredibly consequential for businesses, for households, for investors.

6:52So it's always a good time to write about the neutral rate, interest rates, the cost of borrowing. Why specifically now? Well, it's because something really important has changed from the late 1980s to the mid 2010s. The global economy was characterized by too much saving and not enough investment. And in that state of affairs, the neutral rate of interest, the cost of borrowing was continually falling. What's happened in the last decade? Well, that dynamic has swung into reverse. And now we have less saving, more investment. And that means the neutral rate of interest, the cost of borrowing for the U.S.

7:33Treasury and for everyone else is going up. I like this framing. So it's less about the idea that there is some rate that will bring everything into balance magically, et cetera, because I think a lot of people intuitively understand why You know, that's not such a, you know, I think that probably makes a lot of people uncomfortable. But it is seems objectively true or real that the cost of money or the cost of borrowing has gone up. And so we can talk about that specifically. Let's talk about the cost of borrowing today. Like how much more expensive is it to borrow money today by some measure than it was, say, pre-COVID?

8:10Wait, just before we do this, can we get like a three sentence definition of how you view our star? I feel like we should define our terms before we start. Excellent idea. So R star, the natural rate of interest, is what balances demand for investment and saving in the economy. And when those two things are in balance, the economy is on trend and inflation is roughly a target. All right. That's a simple definition. OK, I like that. All right. So why has it gone up? I mean, this is the big question, right? But actually, before we say why has it gone up, how much has it gone up or has it in fact gone up versus the pre-COVID environment?

8:48Let's start with that. Well, if we cast our mind back to that COVID experience, there was a period where governments could basically be paid to borrow in real terms. Interest rates were so low for so far across the yield curve that they could borrow without having to worry about whether they'd pay it back. So you can see that the real world implications of that and the behavior that we saw during the pandemic, the borrowing that happened, the interest rate was enormously consequential and a big part of that. We're not in that world now. Interest rates, treasury yields in excess of 4 % are much higher, much more burdensome.

9:23And now we're seeing that the costs of those policies manifest in budgets today. So I remember way back in 2016, Goldman Sachs put out this note arguing that the Fed had a big new idea to justify keeping rates low, basically. And the argument was that R-star was low. And so, you know, monetary policy wasn't actually that loose at the time, even though benchmark rates were already pretty low. And the Goldman analysts had this chart in their note where they basically looked at mentions of thematic ideas in Fed speeches and press releases and things like that. And indeed, you could see that starting in 2016, mentions of R-Star start going up.

10:06And, you know, they basically came off of nothing for like the previous decade. No one was talking about the natural rate of interest. I know R-Star itself is an old idea because I read the book and there's a chunky chapter on the history and development of the entire concept. But am I right in thinking that there has been a resurgence in interest in R-Star over the past decade or so? Chunky seems like a neutral adjective, Tracy. How about eloquent? An informative chapter, I should say. So I think there clearly has, right? And I think one of the reasons for that is because the state of the world has changed, right?

10:47In the run up to the global financial crisis, didn't feel like there were sort of fundamental issues with how monetary policy was operating, right? Right. Interest rates moved up, interest rates moved down. The economy responded in the way which the textbooks would suggest. But in the aftermath of the financial crisis, we're in this extended period of economic malaise. Right. And from a monetary policy perspective, it was hard to explain. Interest rates are on the floor. There have been a huge amount of quantitative easing. And yet unemployment rates remain stubbornly high. why growth remained stubbornly low, why was that?

11:27And that's one of the reasons why this neutral rate of interest rose in profile as an explanatory factor. Because if the neutral rate of interest has come down, if it's come down very far, well, that means that central banks have to do a lot to stimulate the economy. And if the neutral rate of interest is close to zero, well, that effectively means that central banks are out of firepower. They can't take interest rates low enough to stimulate growth. This is a very important point, actually. And again, just let's stay in the 2010s here. When interest rates were at zero or near zero for a long time, you probably heard a lot of people in the financial press say, oh, you know, the Fed is super loose monetary policy, et cetera.

12:12How long will the Fed continue to print money or whatever? And yet, looking at the actual results in the real economy, as you've described, unemployment remaining stubbornly high, inflation consistently undershooting. It's in retrospect, very nice problem to have. I think we should have appreciated it more at the time. Really not a problem at all, in my opinion. The implication, though, and we could have understood this from Milton Friedman and some of his talk about Japan, was that actually implicitly we were still running tight monetary policy, even with nominal rates basically at their physical floor.

12:47Yeah. So I guess during that period, Interest rates were low. The economy was failing to gain traction. And policymakers were puzzling over it. And actually, the puzzle continues, right? Policymakers still don't know how a restricted policy is. They infer what they think the natural rate should be by looking around them, seeing what's happening to unemployment, see what's happening to inflation. But they don't know. And so one of the things that we did and we tried to achieve in our book is to rather than inferring the natural rate of interest, we looked over a broader sweep of history and tried to pin down the explanatory drivers of the rate of interest to try and shed some light on why these things are as they are why interest rates fell so much why there was an inflection point around the pandemic and why we think interest rates may therefore go upwards in the future so it was for for us the exercise the book was really about trying to pin down the drivers and then tell a story around those drivers so we can think about That's it in the future.

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15:58Crypto trading provided by Backed Crypto Solutions, LLC. Complete disclosures available at public.com slash disclosure. I feel, Tracy, like this conversation is really about like the magical object that you can't look at, right, because it'll freeze you or maybe it's the shining gold in the briefcase in Pulp Fiction. You can't see it. So all we've done historically mostly is we've attempted to figure out what it is by observing its reflection onto the world, which we observe that reflection, the unemployment. And now this is an attempt to see the unseeable and to actually stare into the abyss at this crucial number and find out what it truly is.

16:35Everyone's been wondering what's in the suitcase in Pulp Fiction. It was R-Star. It was R-Star all along. OK, well, on that note, I mean, I take the point that most of the book is about the specific drivers of R-Star. But you do come up with a model and you do come up with an estimate for the sort of long run trajectory of R-Star. Can you walk us through how your model actually differs from some of the other models out there? Because I think that might help us to understand, you know, when people say this is unobservable or we're sort of staring at the reflection of the economy, trying to come up with this hypothetical number, what we're actually doing or what economists are actually doing.

17:14Yeah, of course. So the conventional way, or at least the way that's been gained a lot of popularity over the past couple of decades, has been the Lau, Back and Williams model of the natural rate of interest or neutral rate of interest. and what they do is they look at what's going on with inflation, what's going on with unemployment and they try to judge from that how far current interest rates must be away from the neutral rate. So if interest rates are very restrictive, very far away from the neutral rate, inflation is going to be very low and unemployment is going to be very high and vice versa.

17:48And this has the benefit of giving you a feel for what's going on right now based on observable data but it doesn't tell you anything about why the interest rate is what it is or therefore where it may go and so what we tried to do was pin the natural rate down by using some actual data and some theory so if we think about what the natural rate is and what it is that determines well it's the price of money and that's determined by in the same way as anything else is determined by the supply and the demand so on the one hand you've got investment demand and then you've got the supply of savings.

18:22And when these two things move, it shifts to the rate of interest. And because of that fundamental theoretical understanding, you're able to think about, well, what is it that determines investment? Why do people want to invest? Why do people want to save? What is it about them or different types of people or different age people that affects their saving behavior? And so you go from that theory to these drivers, these theoretical drivers of behavior, and then you can try and pin it down empirically. And that's exactly what we did. So So we fed into this model, what economists generally think are the main drivers of these investment and saving decisions.

18:57So there are quite a few of them. And then we estimate their relationship with the interest rates over the sweep of, say, 50 years. And that really was what supported our results. And it allows us, of course, then to think about how those drivers may change. Just keeping in mind, Tracy's mentioned in the beginning of defining terms, investment, just so we're clear, this is like real investment, right? So this is hiring impulse, capital expense. What does investment mean in your terms? Yeah. So we're thinking specifically, actually, the capital expenditure. So let's take an example like AI. So AI is great.

19:34I can't do it on a Casio calculator. I have to buy something to make it work. I have to spend money. I have to invest in chips, in fabs to reap the benefits of those frontier technologies. So as AI lifts the growth rate of the economy, it also raises the investment needs. And so this is one of the linkages that we kind of explore is like, what is the relationship between overall growth in the economy and productivity growth, the investment need that creates, and then therefore the knock-on consequence for interest rates. So whether it's ICT revolution in the 90s, railroads, or anything else. These things all have impacts on investment and therefore the natural rate of interest.

20:17And just to define the other term, when you talk about savings, because in a sense, a savings, a loan to a bank, et cetera, but this is the impulse to have sort of liquidity, right? Or at any given moment, the various actors that desire to hold essentially dollar or euro or whatever, liquidity. Yeah, that's right. I mean, I guess you can think about it on the individual level. So I want to save right now. As I get older, I'll want to spend those savings in my retirement. So that's one of the key drivers of saving behavior. China used to save a lot. Now it saves a little. But state actors also matter to the global supply of saving and investment.

20:57So yes, it's everybody and it touches on everything. Yeah. One of the light bulb moments for me reading this book was kind of touching the idea of generational warfare. And the idea that from the 1980s onwards, baby boomers started saving a lot. And so the supply of savings went up and the neutral rate went down. And that's the reason why I never earned interest on my bank account until two years ago. Okay, serious question. In your model, what's the biggest driver of the neutral rate actually going up in the future? Well, in our model, the main driver really is dis-saving by governments or spending by governments.

21:35So there are a number of, I mean, if you look at the recent past, the experience of the pandemic, if you look at the path of the deficit in the US and other countries since then, what we've learned is that governments like to spend and they've continued to do so even though it's become more costly. And a lot of that reflects politics. Politics are fragmented. It's hard to get support around closing budget deficits. And so governments have continued to spend, which is tilting the balance between investment and saving in the global economy. And of course, they have big outlays coming up. Defence spending is going up in much of the advanced world.

22:09The need to green the energy infrastructure, again, in some parts of the world is also crimping saving. And then just that fundamental point that you've got ageing populations, increasing outlays for dealing with that on health, for dealing with that on benefits and pensions. All of this is just making it very difficult to keep spending down. It also intersects with the argument which you kicked off with, Joe and Tracy from Stephen Myron. So Stephen Myron, the new Fed governor, has made the case that the policies from the Trump administration are going to have a big negative impact on the neutral rate of interest.

22:42And that's why he's advocating for very aggressive rate cuts to keep policy accommodative. Now, the argument we make in our book actually points in the opposite direction, right? If you think about the policies of the Trump administration, well, firstly, we've got the one big beautiful bill, which adds trillions and trillions of dollars to government borrowing over the next decade, that significantly pushes up the neutral rate of interest. And if you think more broadly about Trump policies, well, it's kind of the end of the grand bargain which America has struck with the world, right? One way of thinking about the last few decades is America said to the world, we will buy your stuff and we will defend you, but you have to finance us.

23:29You have to send your saving to the United States by US treasuries. But what the Trump administration now is saying is, well, we're not going to buy your stuff and we're not going to defend you. Right. So it wouldn't be that surprising if the rest of the world said, well, if you're not going to buy our stuff and you're not going to defend us, we're not going to finance you anymore. Right. So Stephen Myron, who's a super smart, super articulate guy. And if you've not had him on odd lots already, We have. Fan favorite episode. Makes the case that the Trump administration has significantly lowered the neutral rate of interest.

23:59And that's why the Fed needs to cut aggressively. The model which Jamie developed, the argument we make in our book, actually points in the opposite direction. Yeah. On this note, do you get the sense that central bankers, policymakers, economists sometimes use R-star as a crutch to justify whatever they're doing? Like if you think rates should be lower, then you can just argue that R star is in fact low and R star is this unobservable thing that's based on your own estimates. So you could argue about it, but no one's ever going to prove what R star actually is. And if you think that rates should be higher, then you just argue that, well, actually, something has structurally changed and the natural rate of interest is, in fact, quite high.

24:39Do people use it in that way? It feels like it. But one thing I suppose is that with R-star, you're never beholden to a prediction really, are you? So if you say, I think interest rates should be lower because the economy is going to tank and then the economy doesn't tank, you just look like a bit of an idiot. But if you say, I think rates should be lower because R-star is actually lower, then no one's ever going to come along and say, oh, actually, you are completely wrong because I've got irrefutable proof that R-star was actually in fact higher. So I think it's probably a safe way to express your views if you just have a belief, an inner belief that rates need to be lower.

25:10But it is perhaps one that's less easy to hold to account. When we talk about Trump policies and their effect on our star, another thing that I think about a lot is you talk about this grand bargain falling apart. The trade and every country wanting to be increasingly more self-sufficient in various goods, which strikes me as something that once again adds to the investment impulse. The US is worried that maybe one day we won't be able to rely on Taiwan for chips. Europe might be worried that the US may not be a great supplier for whatever the US supplies to Europe, etc. Does a sort of fracturing of global trade, which may or may not be happening, contribute to a positive investment impulse in a sense and therefore raise our star?