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Real interest rates in the United States have been declining for some time, a trend that was underway already before the global financial crisis. The decline is likely to reflect, in part, global factors, such as higher savings in emerging markets, stronger demand for safe assets, lower investment in advanced economies (Blanchard and others 2014), as well as persistent post-crisis “headwinds” (Yellen 2015). The same factors may have contributed to a decline in unobserved “neutral” or equilibrium real policy rates. Indeed, Federal Reserve Chair Janet Yellen has argued that: “…the equilibrium real federal funds rate is at present well below its historical average and is anticipated to rise only gradually over time as the various headwinds that have restrained the economic recovery continue to abate. If incoming data support such a forecast, the federal funds rate should be normalized, but at a gradual pace” (Yellen 2015).
To better assess the current monetary policy stance, in our recent working paper on the neutral rate in the United States (Pescatori and Turunen 2015), we estimate how the neutral rate has evolved over time and evaluate its determinants. While there are subtle conceptual differences between terms used in the literature— equilibrium,” “natural” or “neutral” rates—we consider the neutral rate as a measure of the real rate that, broadly speaking, is consistent with output at potential and price stability. Our empirical approach builds on the semi-structural empirical framework of Laubach and Williams (2003). The framework is based on an IS-curve equation, which relates output gap to interest rates gaps; a backward looking Phillips curve, which relates core inflation to the output gap; and an equation that links the neutral rate to potential growth and other determinants.
One shortcoming of the previous approach is that it may generate implausible output gap estimates even during periods of well-studied and well-recognized expansions and recessions. To exploit this information—that would otherwise be outside our model—we use a Bayesian approach, which allows us to incorporate prior information on potential output based on a production function approach. We find that our approach provides more plausible results than standard maximum likelihood estimates for the unobserved variables in the model. An additional complication arises because observed policy interest rates have been constrained by the zero lower bound (ZLB) since the onset of the global financial crisis and the Federal Reserve has employed unconventional policies, such as forward guidance and asset purchases, to provide further policy accommodation. We account for this additional accommodation—estimating alternative neutral rates and rate gaps by using existing measures of “shadow” policy rates that are supposed to capture the impact of unconventional policies. Finally, we extend the empirical model to include other observed determinants of the neutral rate.
We find three main results. First, the neutral rate has declined over time and was likely negative during the crisis period (see Figure 1). While there is significant uncertainty in estimates, especially during the global financial crisis, our baseline results show that the neutral rate was likely as low as –1.5 percent during the crisis. Furthermore, our results using a “shadow” policy rate suggests an even lower neutral rate. The baseline results suggest that neutral rates, which bottomed out shortly after the crisis, have been trending upwards thereafter and likely have turned positive during 2014.
While these results do not provide definite evidence on the debate, they nevertheless point to temporary headwinds (opposed by policy accommodation) rather than a persistent secular stagnation scenario where the central bank is consistently unable to stir up aggregate demand. Projections of the neutral rate, conditional on the World Economic Outlook forecast for output, inflation, and an assumption of a gradual normalization in policy interest rates and the Federal Reserve’s balance sheet over time, suggest that the neutral rate is likely to increase only very gradually and to stay well below the Federal Open Market Committee (FOMC) participants’ median forecast for the long-term real policy rate (at about 1.75 percent).
Second, interest rate gaps suggest that monetary policy has been strongly accommodative, especially when taking unconventional monetary policies into account. Real interest rate gaps implied by estimated neutral rates confirm that policy has been accommodative since the crisis started. Owing to the decline in the neutral rate, the baseline rate gap during the global financial crisis was relatively small and comparable to the gap observed during the early 2000s slow growth period (when the output gap was just barely negative). This supports the use of unconventional monetary policies to provide extraordinary accommodation during the global financial crisis. The more negative shadow rate gap suggests that unconventional policies added between 1 to 3 percentage points of policy accommodation. Looking forward, the projected gradual increase in the neutral rate suggests that monetary policy is likely to remain accommodative for some time.
Finally, our results show that the trend decline in the neutral real rate was driven by both lower potential growth and other factors, including higher global savings (see Figure 2). The gradual decline in the estimated potential growth rate since the 2000s is an important determinant of the trend decline in neutral rates. However, we also find that the decline in neutral rates observed since the early 2000s is consistent with a significant increase in demand for U.S. safe assets owing to substantial increases in emerging market current account surpluses during this time period. The results also suggest that other factors, such as increased risk aversion, as well as preference for safer assets, may have further amplified the decline in neutral rates in the 2000s and during the global financial crisis. Looking forward, the projected increase in neutral rates is driven by a gradual recovery in trend growth, which recovers to just above 2 percent, and less downward pressure from other factors.
Blanchard O., Furceri, D. and Pescatori A. 2014. “A Prolonged Period of Low Real Interest Rates?,” in Secular Stagnation: Facts, Causes and Cures. edited by C. Teulings and R. Baldwin, VoxEu Aug. 2014.
Laubach, T. and J. Williams. 2003. “Measuring the Natural Rate of Interest,” Review of Economics and Statistics 85(4): 1063–1070.
Pescatori, A. and J. Turunen. 2015. “Lower for Longer: Neutral Rates in the United States,” IMF Working Paper 15/135, International Monetary Fund, Washington, DC.
Yellen, J. 2015. “Normalizing Monetary Policy: Prospects and Perspectives,” speech given at the “The New Normal Monetary Policy,” a research conference sponsored by the Federal Reserve Bank of San Francisco, March 27.