Is the neutral rate of interest stuck below 1%?

New Evidence for a Lower New Normal in Interest Rates
Bonus: What target should the Fed be shooting at?

This is a stimulative read on a new measure for the neutral rate. To quickly summarize, the neutral rate is important because when the real rate of interest is below the neutral rate then monetary policy is considered to be expansionary. When it is above, monetary policy is contractionary. This is important because as the U.S. central bank continues to increase rates, it will be important they do not break this threshold until they are certain the economy can handle a tightening phase.

It must be noted at the outset that the neutral rate is more theoretical than a precise calculation. This is why, rather than calculate a precise value, the authors at the Fed Reserve Bank in San Francisco use data from TIPS to confirm the downward trend. Now, confirming a trend isn’t groundbreaking, but it does indicate that through multiple means, the neutral rate is very low. And, more importantly, will this lower level persist over the long term?

neutral rate

I tend to side with the camp that argues this lower level is not going to persist over the long term. The first reason is that productivity is an important factor in this equation. As productivity increases, we should see the output gap close and the neutral rate increase. Second, as Treasury yields increase, it will provide upward pressure to the neutral rate. Both of these factors are cyclical in nature (granted they have very long cycles). As I’ve said before on other topics, over the long-term, the economy works itself out.

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