Summers, Blanchard Spar Over Long-Run Level of Interest Rates

(Bloomberg) — Former Treasury Secretary Lawrence Summers took the over while ex-International Monetary Fund chief economist Olivier Blanchard took the under in a good-natured debate on Tuesday about the level of interest rates over the long haul.

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While Summers said he expects rates to be substantially higher on average in the years ahead, Blanchard was more guarded about where they’ll end up settling after inflation is vanquished.

The two top-tier economists – and occasional research collaborators – spoke at a webinar sponsored by the Peterson Institute for International Economics. They did agree rates were unlikely to return to the lows seen before the pandemic, when they were at or near zero, or even below that level in some countries. That’s in part due to increased government debt and deficits.

Where rates settle over time has widespread ramifications for everything from stock and housing markets to monetary and fiscal policy.

At the core of the debate is something that economists call R* — pronounced “r-star” — which is the inflation-adjusted short-term rate that’s neutral for the economy, neither pushing it ahead nor holding it back.

Powell’s Take

Federal Reserve Chair Jerome Powell himself touched on the neutral rate on Tuesday, during a hearing at the Senate Banking Committee.

“It changes over time — this is the thing about these these important variables in economics,” Powell said. After years of declines in neutral rates around the world, now “we have this shock — series of shocks — associated with the pandemic,” he said. “It does raise the question of, Where’s the neutral rate? — Honestly, we don’t know.”

Embedded in their quarterly projections, Fed officials’ forecasts do include an implicit estimate of the neutral rate, comparing their predictions for the long-run policy benchmark rate and long-run inflation rate.

Policymakers currently peg that real rate at just a half percentage point, after a decade in the wake of the 2007-09 financial crisis in which economic growth was mostly sluggish despite low borrowing costs.

Higher rates would raise borrowing costs for homebuyers and the federal government, and lessen the attractiveness of owning shares as opposed to bonds.

While Summers and Blanchard went out of their way to play down their differences, some divergences emerged.

Blanchard, who is a senior fellow at Peterson, argued that an aging population that is living longer will save more, putting downward pressure on interest rates. Harvard University professor Summers wasn’t convinced that would be the case.

Summers, who is a paid contributor to Bloomberg Television, also saw more scope than Blanchard for increased government borrowing in the future, in part to finance stepped-up spending on defense. That would tend to push interest rates up.

Summers suggested at one point that the real neutral rate might be in the range of 1.5% to 2% going forward – a proposition that Blanchard notably didn’t sign on to when asked to respond.