Cleveland Fed researchers say the natural rate of interest has declined; suggest including time-varying estimates of the rate in Taylor rules
Some analysts use a simple equation, the Taylor rule, to anticipate the likely path of the Federal Reserve’s target for the federal funds rate. The Taylor rule suggests that the federal funds rate should be adjusted when inflation deviates from the Fed’s inflation target or when output deviates from the Fed’s estimate of potential output.
One important determinant of the policy prescription given by the Taylor rule is the level of the inflation-adjusted federal funds rate that is expected to prevail in the long run. This rate is sometimes thought of as the equilibrium or “natural” rate of interest in the sense that it is what the economy’s benchmark short-term interest rate would be in the absence of inflation and transient influences.
Typical formulations of the Taylor rule assume that the natural rate of interest is constant over time. However, Federal Reserve Bank of Cleveland researchers Charles T. Carlstrom and Timothy S. Fuerst say there are reasons to believe that the natural rate has declined. “The median forecast of FOMC members for the funds rate in the longer run has fallen from 4.25 percent in January 2012 to 3.30 percent in March 2016,” say the researchers. “Subtracting the Committee’s inflation objective of 2 percent from each of these forecasts means that the natural interest rate fell from 2.25 percent to 1.30 percent.” In addition, the researchers note a decline in what markets expect the real short-term interest rate to be five and ten years from now, and data that suggests that productivity growth — one of the most important determinants of the natural rate — has declined 100 basis points since the start of the recession.
“Our analysis suggests that it may be beneficial for the Fed to include time-varying estimates of the natural interest rate in its deliberations over the appropriate path of the funds rate, and that these responses are warranted whether these movements are temporary or permanent,” say the researchers. “Other things equal, this decline (in the natural rate) would suggest that the post-liftoff Fed may find it appropriate to raise the funds rate more slowly toward historical levels than had the natural rate stayed constant.”
Federal Reserve Bank of Cleveland
The Federal Reserve Bank of Cleveland is one of 12 regional Reserve Banks that along with the Board of Governors in Washington DC comprise the Federal Reserve System. Part of the US central bank, the Cleveland Fed participates in the formulation of our nation’s monetary policy, supervises banking organizations, provides payment and other services to financial institutions and to the US Treasury, and performs many activities that support Federal Reserve operations System-wide. In addition, the Bank supports the well-being of communities across the Fourth Federal Reserve District through a wide array of research, outreach, and educational activities.
The Cleveland Fed, with branches in Cincinnati and Pittsburgh, serves an area that comprises Ohio, western Pennsylvania, eastern Kentucky, and the northern panhandle of West Virginia.
Media contact
Doug Campbell, doug.campbell@clev.frb.org, 513.218.1892
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