Why the Federal reserve will still raise rates: equilibrium real interest rate

by George Hatjoullis

There is a growing consensus that the Federal Reserve will defer starting rate increases because of the China situation and stock market turmoil. This is a false and dangerous perception. The Federal Reserve signalled it is going to raise rates and there is no reason to think it will not do so in September. The reason to believe this is the sudden resurrection of the concept of the equilibrium real interest rate (ERIR). Gavyn Davies highlighted this in a FT Blog on April 2, 2015. This article is still pertinent today.

The ERIR is the short-term real rate of interest assumed to be consistent with the economy operating at potential and stable inflation. When the Fed speaks of normalising interest rates it means returning the Fed Funds rate to this equilibrium rate. The inference is that the Fed believes (or chooses to argue) that the ERIR is higher than the current real interest rate. Gavyn Davies inferred in April that the ERIR is assumed by the Fed to be rising to around 2%.It thus seeks to normalise interest rates by establishing a rate increase path in line with this assumed increase in the ERIR. If the ERIR is 2% then normal Fed Funds would need to be at least 2% even if the expected inflation is zero.

The important point is that the ERIR is not determined by cyclical economic conditions. It is a long-run concept determined by the structure of the economy. The structure does not change from week to week. It is unobservable but presumably the Fed has ether found some way to estimate it or has made an assumption that will justify what it wants to do for whatever reason (for what its worth I favour the latter explanation). In the last analysis it does not matter where the Fed estimate comes from or why they seems set on raising interest rates. An ERIR which is claimed to be above the current real interest rate, and rising, will suffice. If the Fed is using the ERIR to inform policy then there is little reason to expect them to defer interest rate increases any longer.