Rethinking Economics: the equilibrium real interest rate

by George Hatjoullis

The equilibrium real interest rate (ERIR) has entered the policy debate once again. It is an appealing concept because of its simplicity. It is the real short-term interest rate deemed consistent with the economy operating at potential and stable prices, other things being equal. A real interest rate is simply a nominal interest rate minus the expected inflation rate, often known as an ex ante real interest rate( EXRIR). Clearly, as other things are never equal for long, the ERIR is a moving target. The concept is thus only meaningful if it can be assumed that it is stable for long periods or moves predictably.

The ERIR, like all equilibrium concepts, is a steady state variable that emerges from some specific model of how the economy works. The model must yield a unique ERIR and usually will do so by construction. However, the real world need not yield a unique ERIR. The real world is often inconvenient in this way. In 2004, Roger Ferguson of the Federal Reserve asks us:

…to consider what level of the real federal funds rate, if allowed to prevail for several years, would place economic activity at its potential and keep inflation low and stable. (

My immediate response to Ferguson (at the time) was, what am I to assume about the yield curve? The yield curve can be thought of as the implied set of market forward rates. In short it is what the market thinks the Fed Funds rate will be for several years. What if the implied market view of the ERIR differs from that of the central bank? Note that the market view can differ from that of the central bank in an infinite number of ways and may never converge on the central bank view. Economic agents transact at market rates not central bank rates and the path of implied market rates can deviate (and typically does deviate) from actual and expected policy rates. Clearly, implicit in this concept of ERIR is the idea that the central bank controls the yield curve. It does not!

In an open economy there is capital flow and this will be influenced by interest rates, among other things. The flow will be influenced by the real exchange rate and will influence the real exchange rate. So which real exchange rate is being assumed when setting and pursuing an ERIR? (The real exchange rate is the nominal exchange rate adjusted for relative price levels). Is this real exchange rate unique? In any model it can be made unique by construction but in the real world there is no such guarantee.

The Federal Reserve is presently using the ERIR concept to justify a rise in the Fed Funds rate even though there is little evidence of the need to do so in terms of price and wage pressure. The market implied ERIR is lower than the Federal Reserve’s expected path. The real US Dollar exchange rate has risen in anticipation of this Federal Funds policy increase yet the Fed has made no clear statement about the exchange rate, only the ERIR. How can the two be kept separate?

The simplicity of the ERIR as a way of framing policy has seduced both the Fed and economics press into using this concept as the basis for discussion. It is assumed that it is a meaningful concept. It is a construct from economic models which are themselves simplifications. Its uniqueness in such models is by construction but in the real world there may be many real interest rates that are consistent with the economy operating at capacity and stable prices, especially as it is now a global economy.

The importance of uniqueness may not be obvious but then maybe you never had Michio Morishima as a tutor at LSE. The equilibrium concept beloved of economics assumes a unique fixed point (price, output, etc). However, depending upon how one specifies behavioural functions, uniqueness is not automatic. Economics models typically have simplistic (no not simple, simplistic) behavioural functions. So for example Justiniano and Primiceri ( focus on the difference between EXRIR and ERIR which they call the real interest gap (RIR). They continue;

Loosely speaking, if this RIR gap is positive, output will decline relative to potential. This is because people will be inclined to postpone spending decisions today to take advantage of higher returns to savings. All else being equal, a negative output gap will then put downward pressures on prices and wages because of weaker aggregate demand. Conversely, a negative RIR gap will typically be associated with a positive output gap, setting in motion inflationary forces—higher demand leads to higher prices.

The authors have a very simplistic relationship between the RIR and spending, output and prices. Too simplistic.

If we approximate the EXRIR with the implied forward rates of the market then clearly this gap is negative and the Fed risks inflation if it does not raise rates. But this is a logical nonsense since it presupposes the Fed can identify a unique ERIR for the US in a global economy independent of the market. The implied forwards are simply the market estimates of the ERIR and the market has every reason and every opportunity to get their estimates as accurate as possible, If they underestimate the ERIR ( or demand too little risk premium if you prefer) they will collectively lose money. No greater incentive than that to get it right.

The purpose of this blog post is to provide yet another illustration about why the Rethinking Economics movement is on the right lines. Conventional thinking in economics has caused many of the problems we face today. It will cause more if we are not careful. The revival of the ERIR in monetary policy debates is a dangerous development and totally unnecessary. It is quite possible (as I have done in many previous blogs) to set the policy dilemma without ever mentioning this simplistic concept. It is also important to demonstrate that central bankers do not have a monopoly on knowledge being victims of their education. The market, for all its many weaknesses, contains lots of information and the pursuit of financial gain is relentless. The money is smart and it is wise to listen to it. One does not need to be a die-hard advocate of the Efficient Markets Hypothesis to come to this conclusion.

Some will of course find my faith in markets somewhat confusing given what has happened in recent years and the ideological bias of those typically associated with ‘Rethinking Economics’. First, I have no ideological bias, just a conventional economics education and many years experience in financial markets. Second, markets are not necessarily accurate in their forecasts just no worse than anyone else. This is logical as they are everyone. Finally, markets do not cause crises. They can fail in a crisis and transmit the problem to other markets but they are never the cause. Financial crises arise because of debt and leverage. If you removed both it would be hard to engineer a systemic crisis even with a fully functioning market economy. Hence markets are not the cause. Do market participants get carried away and become too greedy? Yes they do. However, without leverage (and hence debt) there is no mechanism for transmitting this problem.

An interesting question can be asked in the light of my previous blog posts and this blog post; are negative risk free bond yields a sign of ‘irrational exuberance’? Obviously, my blog posts are arguing they are not. They are a sign of credit risk aversion and a lack of risk free assets. If people holding these bonds are doing so on a leveraged basis then an unexpected jump in yields may cause a market failure and a serious crisis. However, this is the consequence of the leverage and not the underlying demand for risk free bonds. There is bound to be some speculative activity (and hence leverage) but many of the bond buyers are simply investors with no where else to go. The fact that they are willing to accept zero to negative bond yields is very telling and it is telling me the so called equilibrium real interest rate is lower than the Fed seems to think.