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Investment Research

www.danskebank.com/CI

9 December 2015

The Fed’s theoretical thinking and the importance of the so-called neutral real interest rate

Mikael Olai Milhøj Analyst, Macro Research +45 45 12 76 07 [email protected]

Anders Vestergård Fischer Senior Analyst, Fixed Income Research +45 45 14 69 96 [email protected]

Important disclosures and certifications are contained from page 14 of this document

2 www.danskebank.com/CI

Summary

• The so-called neutral real interest rate is key to understanding why we expect the Fed to increase the Federal funds rate more slowly and why it is likely to stay lower than in previous cycles.

• How accommodative monetary policy is should be measured by the ‘real rate gap’ between the actual real policy rate and the neutral real rate. When the gap is negative, monetary policy is said to be easy; if the gap is positive, monetary policy is tight.

• The neutral real rate is unobservable but estimated by the Fed to be around 0% currently. This implies that the Fed risks tightening too much if it raises rates too quickly given the uncertainty about the true value.

• Thus, in practice, the Fed must monitor the effect on the real economy closely. This is why the Fed says the future rate path will be data dependent and that the hiking cycle will be more gradual compared with previous cycles.

• Pescatori & Turunen (2015) estimate that the neutral real rate will increase very slightly to 1% (3% nominal) in coming years. This means the long-term Federal funds rate is unlikely to get as high as in previous hiking cycles. The median FOMC ‘dot’ for the long-term Federal funds rate in September suggests an end rate of 3.5% (1.5% in real terms). Thus, the FOMC members are in general more upbeat on the long-term neutral rate.


• The ‘neutral real interest rate’ and the ‘real policy rate gap’ are key to understanding the forthcoming hiking cycle. The minutes from the October FOMC meeting and recent speeches from FOMC members (including speeches by Fed Chair Janet Yellen) have revealed that these two concepts are very important to understanding the FOMC’s thinking.

• The neutral real rate is a macroeconomic concept defined as the real interest rate level that would prevail in a situation where the output gap is closed, the economy is growing at trend and inflation is stable. Another way to say it is that the neutral real rate is the rate that equilibrates the market for loanable funds (thus, also called ’the equilibrium rate’ sometimes) assuming a closed output gap.

• The neutral real rate helps to explain why we expect the Fed to increase the Fed funds rate slowly and to a lower level than in previous cycles.

• Theory says that the stance of monetary policy should be measured by the so-called ‘real

policy rate gap’, which is the difference between the actual real policy rate and the neutral real rate, and not by the current level of the nominal Fed funds rate.

• When the actual real policy rate is below the neutral real rate (negative gap), monetary policy is said to be easy, while monetary policy is tight when the real policy rate is above the neutral real rate (positive gap).

Definition of the so-called neutral real interest rate


• The neutral real rate is the rate that equilibrates the market for loanable funds (thus, also called ’the equilibrium rate’ sometimes) assuming a closed output gap.

• Anything that shifts the supply curve to the right (i.e. more supply for a given real rate) or the demand curve to the left (i.e. less demand for a given real rate) lowers the neutral real rate (solid lines with dashed lines).

• Among other things, the neutral real rate depends on productivity growth, the price of capital, investment profitability, fiscal policy, demographics, relative demand for bonds and the relative risk of equities.

Source: IMF WEO 2014

Determinants of the neutral real policy rate


• It is important to recognise that the neutral real rate is unobservable and first and foremost a theoretical/hypothetical concept. We cannot be sure what the true value of the neutral real rate is, we can only try to estimate it. Different models, estimation methods, data and so on imply that we get different results (as indicated by the chart overleaf), which adds to the uncertainty about the true value.

• Most researchers agree that the neutral real rate declined during the crisis and some even argue that it went negative when the crisis was at its worst.

• The fall in the neutral real policy rate was due to a combination of the following.

− Slower trend growth.

− Lower investment demand due to the severe crisis.

− Lower price of capital leading to less demand for funds.

− Emerging markets savings glut.

− Safe-haven capital flights, which increased the demand for safe US assets.

Neutral real rate declined during the crisis


Different models find different values of the neutral rate

Source: Federal Reserve

http://www.federalreserve.gov/newsevents/speech/yellen20151202a.htm

http://www.federalreserve.gov/newsevents/speech/yellen20151202a.htm


Estimated real policy rate gaps

• At the beginning of the crisis, the Fed lowered the Federal funds rate to the target range 0.00-0.25%, implying a negative real policy rate when subtracting expected inflation.

• However, monetary policy was not as accommodative as on first sight. As the neutral real rate also declined, the real policy rate gap did not fall as much as the real policy rate.

• This is one of the reasons why the Fed launched its asset-purchase programmes as lowering the Fed funds rate was not accommodative enough to offset the negative impact of the Great Recession.

• Pescatori & Turunen (2015) estimate that unconventional tools made monetary policy 1-3pp more accommodative than otherwise (as illustrated by the shadow rate gap in the chart on the right).

Source: Pescatori & Turunen (2015)


• Most Fed models indicate that the neutral real rate is 0.00% at present. The uncertainty about the true neutral real policy rate is a key reason why the Fed is likely to move slowly after the lift-off. The US and the rest of the developed world have been through a very severe crisis and the Fed wants to make sure that it does not increase the Fed funds rate too quickly.

• Assuming that the true neutral real rate is, for example, -0.25%, the current stance of monetary policy is already relatively tighter than if the true neutral real rate were 0.00%, as the real rate gap is smaller from the start.

• This is why FOMC members have said that the hiking cycle will be gradual and data dependent, as they want to see how the real economy will be affected by the hikes.

• The more the economy slows, the more likely it is that the current neutral real policy rate is lower than the point estimate of 0.00% and vice versa.

Neutral rate is unobservable – in practice Fed must try and see


Neutral real interest rate vs actual real rate

Note: We have used the neutral real interest rate calculated using the method by Laubach & Williams (2001). Note that the neutral rate according to their method did not become

negative during the crisis. This is not in line with other papers, which get a negative neutral real interest rate (as illustrated on page 6).

Source: Federal Reserve, Atlanta Fed, Wu & Xia (2014), Laubach & Williams (2001), Danske Bank


• Pescatori & Turunen (2015) estimate that the neutral real rate will increase slightly in the coming years to around 1% in 2020 (uncertainty range 0.4-1.6%).

• This means the long-term Fed funds rate is unlikely to reach as high as in previous hiking cycles. Assuming that the long-term neutral interest rate is 1%, it implies the long-term Fed funds rate is 3% (or in the range 2.4-3.6% due to the uncertainty surrounding the point estimate) according to the Fisher equation.

• The median ‘dot’ for the long-term Fed funds rate in the FOMC’s September projection was 3.50%, which is at the upper end of the uncertainty range. Thus, the median FOMC member is a bit more upbeat on the neutral real policy rate than the point estimate in Pescatori & Turunen (2015).

• If the point estimate of 1% turns out to be right, the long-term ‘dots’ from the September projections could be revised down further going forward. The long-term median ‘dot’ has already been revised down 75bp from 4.25% in January 2012 to 3.50% in September 2015.

• It is also worth noting that the different views among the FOMC members on the long-term Fed funds rate imply that they disagree on the level of the long-term neutral real policy rate. The current ‘dots’ indicate a range of 1-2%.

Neutral rate should increase only slightly in coming years,

explaining why long-term Fed funds rate is lower


NEUTRAL REAL RATE IN A NEW

KEYNESIAN FRAMEWORK

APPENDIX


• The importance of the ‘real rate gap’ can be illustrated in a simple New Keynesian (NK) macroeconomic model. NK models have become workhorses for analysing monetary policy both academically and within central banks.

• Without going into too much detail, the simple NK model consists of a supply side and a demand side of the economy and a central bank controlling the nominal interest rate.

• The first equation is the NK Phillips Curve (NKPC), which is usually interpreted as the supply side of the economy. NKPC describes the relationship between the current inflation rate, the expected future inflation rate and the output gap:

• Where πt is the inflation rate at time t and xt is the output gap (defined as the difference between the actual output and potential output). Potential output is the output that would prevail in the long run when prices and wages have adjusted) and Et is the expectation operator given what you know at time t (the so-called information set), implying this is the expected future inflation rate at time t+1 conditional on what

you know at time t. κ and β are coefficients.

• Inflation depends positively on the output gap. If the output gap is positive (i.e. actual output > potential output), the economy is ‘hot’ leading to higher inflation. Inflation depends positively on future inflation, as prices are sticky and thus firms take the future into account as they know they cannot adjust their prices frequently.

Neutral rate in a New Keynesian model


• The second equation is the so-called IS curve, which is usually interpreted as the demand side of the model. The IS curve describes the relationship between the current output gap, the expected future output gap and the real interest rate gap.

• Where Etx t+1 is the expected future output gap at time t+1 condition on what you know at time t, it is the nominal interest rate at time t and rn

t is the neutral real interest rate at time t. The time notation is because the neutral interest rate is not necessarily constant over time. σ is a parameter.

• The Fischer equation states that the current real interest rate is the nominal interest rate minus

expected inflation, i.e. it- Etπt+1=rt . Therefore, as mentioned, the IS curve relates the output gap with the real interest rate gap. Disregarding the expected future output gap, the output gap will be positive when rt < rn

t and negative when rt > rnt .

• Although the simple New Keynesian model is only a simplification of the real economy, it suggests

theoretically why the stance of monetary policy should be judged by the sign of the real rate gap and

not by the level of the nominal interest rate.

• The Fed is afraid that it may tighten too quickly such that rt > r

n

t and it slows the economy too much.

• If rn

t does not get back to the same level as before the crisis, then i

t cannot either in the new

equilibrium.

Neutral rate in a New Keynesian model


Disclosures

This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske Bank’). The authors of this research report are Mikael Olai Milhøj, Analyst Macro Research and Anders Vestergård Fischer, Senior Analyst Fixed Income Research.

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