Interest Rate Equilibriates Savings and Investment: Wicksel

Moneybox:

Swedish economist Knut ...Wicksell argued that there is a “natural rate of interest,” at which desired savings is balanced by desired investment and the economy suffers from neither inflation nor massive excess capacity. A recession occurs when the natural rate of interest falls below the actual interest rate. Instead of savings being channeled into investment and driving the economy forward, firms and households start merely hoarding and the economy stalls, leaving workers and equipment idle.

Wicksell’s work leaves open the question of why the natural rate of interest might rise or fall, so it doesn’t make for much of a causal theory of recessions. But under normal circumstances central bankers can cure recessions by cutting interest rates to bring them closer to the natural rate. This brings saving and investment back into equilibrium and ensures that resources are put to good use.

Unfortunately, the financial crisis we’ve been suffering through pushed the natural rate very low—below zero. The Fed can’t set the nominal interest below zero, and has steadfastly refused to engage in the variety of “unorthodox” measures that would push real rates lower...

The Fed knows it could do more, but it would probably only do more if the economy hurt the profits at Wall Street Banks.  The Fed simply does not care enough about unemployment to try to use its "unorthodox" tools.  We need unorthodox tools because of the liquidity trap.  President Bush's chief economist, Greg Mankiw estimates that we needed unorthodox monetary policy:

I wrote a paper on monetary policy in the 1990s .... I estimated the following simple [Taylor rule] formula for setting the federal funds rate:

Federal funds rate = 8.5 + 1.4 (Core inflation - Unemployment).

Here "core inflation" is the CPI inflation rate over the previous 12 months excluding food and energy, and "unemployment" is the seasonally-adjusted unemployment rate. The parameters in this formula were chosen to offer the best fit for data from the 1990s....
Eddy Elfenbein has recently replotted this equation.  Here it is:

The interest rate recommended by the equation is the blue line, and the actual rate from the Fed is the red line.

Not surprisingly, the rule recommended a deeply negative federal funds rate during the recent severe recession.  Of course, that is impossible, which is why the Fed took various extraordinary steps to get the economy going.  But note that the rule is now moving back toward zero.  As Eddy points out, "At the current inflation rate, the unemployment rate needs to drop to 8.3% from the current 8.5% for the model to signal positive rates. We’re getting close."

I won't go on record to predict that we are only 0.2 percentage points of unemployment away from rapid growth, because the sort of "Taylor rule" ideal (the blue line) that Mankiw estimated is always changing and it is easier to plot in hindsight, but I agree that we are getting closer to the tipping point where faster recovery is likely.