There is an economic debate over the affect of rising interest rates upon the R*, otherwise known as the natural rate of interest, the Wicksellian rate, the Equilibrium rate, or the neutral rate. The definition of the natural rate is as follows:

The concept was originated by the Swedish economist Knut Wicksell who published a paper in 1898 defining it as a real short-term rate that makes output equal to natural output with constant inflation. Specifically, Wicksell defined the NRI as “a certain rate of interest on loans which is neutral in respect to commodity prices and tends neither to raise nor to lower them”.

It is hard to argue that the Fed cares much about the natural rate, since commodities often rise forcefully, and the cost of living is pinching main street. However, it says it does care, that it cares about price stability as one mandate. So what it plans to do with regard to the rate is the bone of contention for economists.

In this article it is necessary to discuss Scott Sumner's views along with Kevin Erdmann's views, with a mention of Donald Trump's effort to corral the Fed. These ideas are counter-intuitive to what the Fed is doing, and yet absolutely sound assessments in normal economic times.

Unfortunately, we are not living in normal economic times.

The Brookings Institute has introduced an article entitled Measuring the Natural Rate of Interest Redux. The most significant conclusion made there is:

Given the uncertainty surrounding any estimate of the natural rate, they argue it might be prudent for the Fed to move away from relying on such estimates as a gauge for setting monetary policy. Second, if rates stay low for a prolonged period of time, Fed interest rates may be close to zero more often, suggesting a frequent need for unconventional monetary policy and the need to consider raising the Fed’s inflation target above its current 2% level. [Emphasis Mine]

The difficulty of measuring the natural rate of interest is key to their conclusion, so at least, they say, inflation should be allowed to run a bit. But it appears that this desire for inflation is not in the Fed's DNA anymore. The experiment of the 1970's and the destruction of the Savings and Loans due to inflation and interest rising is not going to be palatable to the Fed, especially when it also allows wages to fly. That is a Fed no no as well.

Market monetarists like Scott Sumner and Kevin Erdmann say raising of rates instead of raising inflation will result in the dropping of the R* rate. They opt for a similar argument to this Brookings suggestion, that inflation be allowed to run as a means of raising the natural rate of interest rather than stopping inflation in its tracks. This of course makes perfect sense, but it requires breaking the New Normal, a risky journey at best.

Sumner expresses this wisdom in an interesting article that is helpful except for his continued assertion that there are no bubbles. I countered that argument, in the article, Yes There WAS A Housing Bubble. In addition, it can be said that bubble markets were so liquid with easy money loans to anyone with a pulse back then that they went against the concept in real estate that is basic, and that is that real estate is illiquid! For a time that fundamental real estate concept was not applicable to property in the bubble years. This liquidity in housing was proof alone of the bubble.

But back to his main point, Sumner takes issue with Martin Feldstein, when he says that raising the interest rate when the economy was strong would allow for a cushion from the Zero Lower Bound when recession hits. Interest rates need to be lowered when there is a slowdown, so why not jack them up according to Feldstein and traditional economics.

Sumner would no doubt agree with the eventual need to lower rates, but believes that raising rates reduces the R* (Wicksellian) rate. He said:

Raising interest rates reduces the Wicksellian equilibrium interest rate.  That gives the Fed less room to cut rates in the future.  The Fed does monetary stimulus by cutting rates below the equilibrium rate.  The lower the equilibrium rate, the less room there is to use conventional monetary stimulus.

This of course, puts the Fed into a box. It needs to let in a little inflation balance things, but it just can't with all the structured finance (new normal) created with the help of Alan Greenspan. 

Kevin Erdmann gave me this bit of insight in an email. He contributes to the Mercatus Center along with Dr. Sumner:

I don't say that there are never "bubbles". I am a tactical investor, which means that I count on mispricing. I just think extreme mispricing is rare, and loose credit is not enough to produce one. Reno can be said to have had a bubble, but the root cause was a migration event that swept over it. Much like how housing is expensive in North Dakota bc of the oil rush.
The way to keep rates from being too low in the recession would be to lower them today. [Emphasis Mine]

This need to lower rates now is indeed counterintuitive. Yet if we are concerned about the natural Wicksellian R* rate, it makes perfect sense and is consistent with Sumner's position and with Brookings. Lowering rates today could increase inflation and ultimately interest rates and the natural rate would follow upward. That is assuming that commodities are not soaring nor house prices.

So it seems the only issues with this common sense approach is that bonds are in massive demand as collateral and wages could soar. It is estimated that the collateral market for interest rate bonds is about 13 trillion dollars after netting. If 13 trillion dollars of net value counterparty credit risk blew up with high interest rates, there would likely be economic chaos. Just imagine big margin calls on 13 trillion dollars of bonds! Those bonds are marked to market daily. And wages need to soar a little, because the Fed has tamped them down for so long.  

I told Ellen Brown this via email:

They (treasury bonds) are used as collateral in massive amounts. So massive margin calls would cause chaos if yields rose significantly. Thank Greenspan and structured finance for this new normal. And for the conundrum.

It is necessary that we understand that nothing short of a planned attack on the financial system will change the new normal without a change in collateral. Long bonds should be replaced as collateral, or the Sumner/Erdmann fix, which makes perfect sense in normal times, will not be permitted by the Fed. In Asia, commodities are often used as collateral. Perhaps our financial system should move to that method, but even that would likely cause disruption in the bond markets.

If POTUS leans on the Fed, or gains control of the Fed, and blasts open the financial system, all hell could break loose. Yet that may be the only plan to combat the system that Greenspan built. But this attack it is a plan permeated with and fraught with serious financial DANGER. Even helicopter money would have to make more sense than busting up the new normal with the weapons of mass destruction ready to explode.

The Fed is in a box because it can only promote tepid growth but the residents on main street are getting restless. The Fed is also riding a high wire, and it is not problematic to see that it will have trouble balancing on that rope forever. Its preferred way of escape is a crashing of stocks and a recession.