A variance analysis of future short-term interest rates

Normal vs. Neutral Interest Rates: Parsing Controversies About Future Short-Term Interest Rates

Disagreements over how much monetary policy should be tightened are strong at the moment. We illustrate this using private sector financial forecasts collected in the monthly Bluechip survey. Figure 1 shows the average of the ten highest forecasts minus the average of the ten lowest forecasts for the three-month US T-bill rate, an interest rate very closely linked to the federal funds rate. For the fourth quarter of 2023, the spread between the highest and lowest forecasts was 1.5% and 1.7% in the May and June surveys, respectively, larger than in early 2021.

Figure 1 Disagreement over future short-term interest rates

Comment: Data from Bluechip Financial Survey (via Havar)

Going further back in history, the size of the current divergence is roughly consistent with the long-run average, which the literature on forecast divergence finds surprisingly high. Andrade et al. (2014), the authors document that, on average, since 1980, disagreement about future Fed funds rates has been increasing with forecast horizon and peaks at about 2% for horizons of 6 to 11 years (see also Andrade et al. 2016). In a recent Vox column, Martinez-Garcia and Dohr (2022) argue that disagreement is a sign of policy uncertainty and explain how it complicates central bank expectations management efforts.

Rate component of nominal monetary policy

To better understand the sources of disagreement, we decompose the nominal short-term interest rate into its components:

All three elements are important in our view to explain the ongoing disagreement. This column is a first step, where we separate the three components and focus on clarifying the true neutral rate component.

The so-called real neutral interest rate is the level of real interest rates consistent with stable inflation and potential output.1 If the real monetary policy rate is below the neutral level, the monetary policy stance is expansionary. If it is high, monetary policy is contractionary, putting downward pressure on aggregate demand and consequently on inflation and the output gap. With inflation currently running above target and short-term interest rates still low, economists argue that central banks should raise interest rates to at least the neutral rate level.

Our main point in this column is that the true neutral rate has a slow-moving, long-running component as well as a short-running component, and that lack of clarity about this distinction may explain a significant portion of the current disagreement.

Neutral vs Normal Interest Rate

In the current debate, it is often unclear whether discussants are talking about the neutral rate (‘short-run R*’) or the natural rate (‘long-run R*’ or ‘long-run neutral rate’). The terms are often used interchangeably but, although closely related, the two underlying concepts derive from different types of economic models and the distinction is important at the present juncture.

The natural The interest rate, or long-run R*, is derived from the economic growth literature. We define it as the risk-free return that equalizes the demand and supply of savings in long-run equilibrium, with no shocks. Models in this literature link natural rates to slow-moving variables, such as population demographic characteristics (such as fertility rates, life expectancy), income inequality, and productivity growth (Platzer and Perufo 2022). The definition states, natural Interest rates themselves are slow moving and not affected by temporary shocks.

on the contrary, neutral The rate, or short-run R*, is derived from the New Keynesian DSGE model and simulates the real interest rate that would prevail in an economy without nominal rigidity. Central banks use hypothetical interest rates as benchmarks to eliminate inefficiencies caused by nominal rigidity. Some economic shocks may temporarily shift this benchmark. This is why neutral rates can exhibit significant short-term movements.

It’s helpful to think about it neutral As the rate fluctuates around natural Rate in a steady manner.2 Figure 2 illustrates this by plotting the neutral rate estimate from the Laubach-Williams model along the long-run trend. Although small in recent years, the difference between the neutral rate and its long-term trend (the natural rate measure) has been large during several episodes.

Figure 2 Normal vs neutral rate of interest

Comment: The neutral rate is an updated estimate of the Holston-Laubach-Williams model downloaded from the NY Fed website. The natural rate is the long-term trend component of the neutral rate, extracted with the HP filter.

What kind of factors can drive a wedge between normal and neutral rates of interest? In the workhorse model by Smets and Wouters (2003, 2007), some transitory shock—for example, productivity or government spending—can temporarily move the neutral rate away from its long-run value (the normal rate of interest).

In the current debate, a popular argument maintains that many determinants of interest rates, such as population and productivity, have not changed much since the pandemic and are unlikely to reverse anytime soon. Consequently, the argument goes, the level of R* should not change from the pre-pandemic level of about 0.35% (based on the widely cited Laubach-Williams and Holston-Laubach-Williams models). This type of argument misses the point that there are other determinants than slow moving ones, which may very well vary from epidemic to epidemic. For example, the US has massive fiscal stimulus (such as the spring 2021 US $1.9 trillion American rescue plan). In a range of New Keynesian models, unexpected and transitory increases in government spending are predicted to temporarily raise the neutral rate. In the current context, this would mean that the neutral rate is above the normal rate of interest. While this gap should be expected to close over time, at the current juncture, it would be the higher neutral rate that is the appropriate target level for monetary policy, not just the fixed natural rate component.

Inflation Expectations and Fiscal Position

As monetary policy sets nominally Interest rates, economists need to consolidate their views real Neutral rate with a measure of inflation expectations. The latter is another important source of disagreement because, in practice, inflation expectations are difficult to accurately measure. For example, some economists use their expectations understood Inflation in 2023, others may speculate where short-term inflation expectation will be in 2023, and yet another group may use the Fed’s inflation target. More generally, uncertainty about the future path of inflation is high in the current hyperinflationary environment. We leave the issue of measuring appropriate inflation expectations to future commentary.

Finally, the expected monetary position, which is the sum of the actual neutral rate and expected inflation minus the nominal rate, captures the extent to which the nominal policy rate deviates from neutral. This will depend on a variety of factors including deviations of inflation and economic activity from target levels as well as trade-offs and choices between various central bank objectives. For example, consider a temporary cost-push shock that leads to above-target inflation. In standard macroeconomic models, such a shock leaves the neutral real rate unchanged. In such a situation, the central bank faces a choice between driving output as low as possible or raising real rates to fight inflation at the cost of keeping interest rates stable and tolerating high inflation. Economists’ expectations about financial position are difficult to measure because there is no single underlying concept, nor is financial position the subject of survey questionnaires. Discussions in the media suggest that economists’ views on the future financial position range from ‘neutral’ to ‘fairly neutral’.

Conclusion

An accurate prediction of future short-term policy rates requires analyzing all the underlying factors In this column, we argue that the current debate over the measurement of the real neutral rate is ambiguous, which may explain part of the disagreement about the short-term policy rate. By clarifying the concepts of normal and neutral interest rates, we hope to contribute to streamlining the discussion and reducing disagreement.

Author’s Note: The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.

reference

Andrade, P, R Crump, S Eusepi and E Moench (2014), “Learning from disagreement: Evidence from forecasters”, VoxEU.org, 23 December.

Andrade, P, RK Crump, S Eusepi and E Moench (2016), “Fundamental disagreements”, Journal of Monetary Economics 83: 106–128.

Holston, K, T Laubach and JC Williams (2017), “Measuring the Natural Rate of Interest: International Trends and Determinants”, Journal of International Economics 108: S59–S75.

Laubach, T and Jesse Williams (2003), “Measuring the Natural Rate of Interest”, Review of Economics and Statistics 85(4): 1063-1070.

Martinez-Garcia, E and R Dohr (2022), “Interest rate expectations shape path of Federal Reserve’s hike”, VoxEU.org, 6 March.

Platzer, J and M Peruffo (2022), “Secular drivers of the natural rate of interest in the United States. A Quantitative Assessment”, IMF Working Paper No. 2022/030.

Smets, F and R Wouters (2003), “An Approximate Dynamic Stochastic General Equilibrium Model of the Euro Area”, JAnnual of the European Economic Association 1(5): 1123-1175.

Smets, F and R Wouters (2007), “Shocks and frictions in US business cycles: A Bayesian DSGE approach”, American Economic Review 97(3): 586-606.

Endnote

1 The true neutral level of interest is unobservable and can only be estimated with high uncertainty.

2 DSGE models are usually solved and analyzed in terms of deviations from steady state. The steady state is the solution of the model in the absence of any transient shock. With some simplifications, this corresponds closely to the solution of a very simple growth model. This motivates our suggestion to think about the neutral rate fluctuating around the natural rate.

3 Andrade et al. (2016) explain high disagreement about long-run nominal policy rates with disagreement about long-run inflation and output. This is consistent with both our points about the real neutral rate and inflation expectations.

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