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 crosscountry 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

Measuring the Natural Rate of Interest: International Trends and Determinants

“…This finding is robust to alternative methodologies (Hamilton et al 2015;Kiley 2015;Lubik and Matthes 2015;Laubach and Williams 2016). 1 In this paper, we extend this analysis to other advanced economies.…”

Finding the Equilibrium Real Interest Rate in a Fog of Policy Deviations

“…for monetary policy as discussed in Carlstrom and Fuerst (2016), Dupor (2015), Hamilton, Harris, Hatzius and West (2015), Summers (2014) and Yellen (2015). Indeed, several U.S. policy making or policy advising organizations have reported estimates or ranges of estimates of the equilibrium real interest rate based on such studies, including the Congressional Budget Office, the Office of Management and Budget, the Federal Open Market Committee, as well as professional forecasters and financial market participants, as Cieslak (2015) has documented.…”

“…Laubach and Williams (2015) and Hamilton, Harris, Hatzius and West (2015) argue that uncertainty about r* means that policy makers should use inertial Taylor rules, with a 14 lagged interest rate on the right hand side along with other variables. There are other reasons for doing this in the literature and it is not a very radical idea.…”

Endogenous Forecast Switching Near the Zero Lower Bound

“…5 See, for example, Eggertsson and Woodford (2003), Adam and Billi (2007), Nakov (2008), Nakata (2013), Hamilton, et al (2016), Basu and Bundick (2015), Evans, et al (2015), and Gust, Johannsen, López-Salido (2017). 6 See, for example, Evans and Honkapohja 2005, Eusepi 2007, Evans, Guse, and Honkapohja 2008, Benhabib, Evans and Honkapohja 2014, and Christiano, Eichenbaum, and Johanssen 2016 …”