A couple of weeks ago Larry Summers held a widely praised speech on the difficulties ahead for economic stabilization policy. As far as I can tell, not much of it was really new, as also pointed out by e.g. Krugman, but that does not mean it wasn’t a great speech, and one that seems to have had considerable influence on the policy debate. In essence it boils down to the problems we face due to the zero lower bound on nominal interest rates, and what happens in a world where the real interest rate required to establish full employment, sometimes also called the natural real interest rate, is negative, as it almost certainly is right now. Yet from the regression’s I have been running, it would seem that the equilibrium real interest rate was already considerably lower than in previous periods even before the crisis started. In other words, even before the crisis struck, monetary policy already had considerably less room to maneuver than in the decades preceding the the 2000s. To recap, let’s again take a look at a fairly simple Taylor rule one might use to describe Fed policy in the 2000s, more precisely from the first quarter of 2000 to the second quarter of 2009, which is roughly around the time when the zero lower bound started binding.
Conceptually, a Taylor rule such as the one above has two straight-forward offsets: the equilibrium interest rate and the inflation rate in period t. Econometrically it is impossible to estimate both separately, meaning that one has to be held constant in order to achieve a meaningful separation directly through the regression. In my case the choice was easy, as I was basically trying to do ex-post estimations of what Fed policy was like during a given period of time, meaning I have accurate data on the inflation rate in period t, leaving only r* unknown.
The interest lag introduced to the Taylor rule essentially represents a third, also time-variant offset that has to be taken into consideration. Conceptually, even if both the unemployment gap and the inflation gap are 0, i.e. the central bank fully achieves its targets, the nominal interest rate it sets will still be determined not only by its estimate of the equilibrium real interest rate and the current (i.e. target) level of inflation, but also to a certain degree by the nominal interest it set in the previous period. Long story short, given the Taylor rule stated above, if we assume the central bank does not consistently miss its targets (which it doesn’t over my sample), we can calculate the approximate equilibrium real interest rate as implicitly assumed by the central bank by taking the intercept value (the estimated offset of the recession) and adding to it the weighted interest smoothing term.
The graph above represents this implicit equilibrium real interest rate over the period in question. Note that this is not strictly speaking the natural real interest rate, which is notoriously difficult to calculate, but rather reflects the beliefs held by the central bank (as derived from an estimated Taylor rule that describes the actual behavior of the central bank in a sufficiently accurate way) with regards to what it assumed the equilibrium real interest to be. The apparent fact that this rate fluctuates considerably provides plenty of room for interpretation by itself. And even though there is considerable uncertainty regarding the precise values, the mean value for the example in question is pretty interesting: it is roughly 1.34%. As a comparison, the original Taylor rule paper assumed an equilibrium real interest rate of 2%, while Judd et al. (.pdf) for instance estimated a value of around 2.82% for the Greenspan years up to 1997. No matter how I specify the Taylor rule, I always get results that lie considerably below the 2% mark often simplistically assumed as being a kind of “historic average”.
Why does this seem to be the case? My guess is as good as yours, yet it is of vital importance for policy discussions. If the real equilibrium interest rate is lower, a lower nominal interest rate is needed to achieve the same level of inflation. Put differently, given a fixed inflation target, the likelihood of running up against the zero lower bound on interest rates is higher the lower the real interest rate is. In other words: not only was monetary policy in a tough spot because it faced an economic crisis bigger than any other seen since the great depression, it was also from the very start more constrained by the zero lower bound than in previous decades, limiting its ability to stimulate the economy at a time when we needed stimulus the most.