The Equilibrium Real Funds Rate: Past, Present, and Future

Abstract

We examine the behavior, determinants, and implications of the equilibrium level of the real federal funds rate, defined as the rate consistent with full employment and stable inflation in the medium term. We draw three main conclusions. First, the uncertainty around the equilibrium rate is large, and its relationship with trend GDP growth much more tenuous than widely believed. Our narrative and econometric analysis using cross-country data and going back to the 19th Century supports a wide range of plausible central estimates for the current level of the equilibrium rate, from a little over 0% to the pre-crisis consensus of 2%. Second, despite this uncertainty, we are skeptical of the "secular stagnation" view that the equilibrium rate will remain near zero for many years to come. The evidence for secular stagnation before the 2008 crisis is weak, and the disappointing post-2008 recovery is better explained by protracted but ultimately temporary headwinds from the housing supply overhang, household and bank deleveraging, and fiscal retrenchment. Once these headwinds had abated by early 2014, US growth did in fact accelerate to a pace well above potential. Third, the uncertainty around the equilibrium rate argues for more "inertial" monetary policy than implied by standard versions of the Taylor rule. Our simulations using the Fed staff's FRB/US model show that explicit recognition of this uncertainty results in a later but steeper normalization path for the funds rate compared with the median "dot" in the FOMC's Summary of Economic Projections.1

Some Evidence on Secular Drivers of US Safe Real Rates

“…Conversely, in row (1c) correlations between world GDP growth and safe rates are positive in the 1890-2016 sample, but have mixed signs and are relatively small in the 1950-2016 sample. These findings that positive correlations between economic growth and real rates are episodic corroborate earlier research (Leduc and Rudebusch (2014), Hamilton et al (2016)). Further, in our view, the mixed picture of signs and significance is consistent with the large literature that finds the intertemporal IS equation wanting (e.g., Canzoneri et al (2007)).…”

“…The results reported here and in earlier research (e.g., Hamilton et al (2016)) suggest that in the data the low frequency link with GDP growth is episodic, and the link with TFP growth is negative. A reduced form result that, so far as we know, is new to this paper is that labor hours is a strongly positive low frequency correlate of the safe real rate.…”

“…However, the results in this paper and in research such as Leduc and Rudebusch (2014) and Hamilton et al (2016) suggest that GDP growth and real rates do not show a reliably positive low frequency correlation. Now, GDP growth is driven by both productivity and labor hours growth.…”

“…Some literature has extended the utility function to allow habit persistence. As explained in Hamilton et al (2016), such an extension does not have important implications for trend real rates.…”

“…Our list of variables includes ones consistent with the logic of DSGE models that dominate monetary economics today. For example, a first order condition similar to (1) is ubiquitous in such models; even when (1) is generalized to allow features such as habit persistence there is still a link between trend growth and low frequency movement in r (see Hamilton et al (2016)). Some such models include technology shocks that lead to a trend in the relative price of investment (e.g., Justiniano et al (2011)).…”