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November 7, 2009

Economist's View - 6 new articles

Things are the Same Here, But Different

Let's see, should I sit in my hotel room and blog to make up for not writing much over the last few days, or go wander around Munich.

See ya.

What's Wrong with Modern Macroeconomics? - Conference Papers

What's Wrong with Modern Macroeconomics?

CESifo Conference Centre, Munich 6 - 7 November 2009


Friday, 6 November 2009

Session I Chair: Gerhard Illing

09:00 – 09:50 The Roles of Ideology, Institutions, Politics and Economic Knowledge in Forecasting Macroeconomic Developments ALEX CUKIERMAN (Tel-Aviv University) (via video link) Discussant: Panu Poutvaara (University of Helsinki) 09:50 – 10:40 Uncertainty, Risk-taking and the Business Cycle FRANK SMETS (ECB) Discussant: Camilo E. Tovar

Session II Chair: Efraim Sadka

11:00 - 11:50 Macroeconomic Agenda: Compare Competing Paradigms and Identify Robust Policy Recommendations VOLKER WIELAND (Goethe University Frankfurt) Discussant: Antonio Spilimbergo (IMF) 11:50 – 12:40 Liquidity Constraints and Non-market Clearing: A Recipe for Recession? John Drifill and MARCUS MILLER (University of Warwick) Discussant: Jouko Vilmunen (Bank of Finland)

Session III Chair: Paul de Grauwe

14:00 – 14:50 Analysis of Monetary Policy and Financial Stability: A New Paradigm Charles Goodhart, Carolina Osorio and DIMITRI TSOMOCOS (Oxford University) Discussant: Daniel Gros (Center for European Policy Studies) 14:50 – 15:40 Unemployment Risk and Aggregate Consumption Behaviour XAVIER RAGOT (Banque de France) and Edouard Challe Discussant: Efraim Sadka (Tel-Aviv University) Panel discussion Moderator: Robert M. Solow Panellists: Hans Gersbach, Charles Goodhart, Hans-Werner Sinn, Mark Thoma, Martin Wolf

Saturday, 7 November 2009

Session IV Chair: Volker Wieland

8:30 – 9:10 Top Down or Bottom Up Macroeconomics PAUL DE GRAUWE (University of Leuven) Discussant: Casper de Vries (University Rotterdam)

9:10 – 9:50 The Economic Crisis is a Crisis for Economic Theory ALAN KIRMAN (G.R.E.Q.A.M.) Discussant: Mark Thoma (University of Oregon) 9:50 – 10:30 Reconstucting Macroeconomics: More is Different THOMAS LUX (University of Kiel) Discussant: Pablo Rovira Kaltwasser (University of Leuven)

Session V Chair: Hans Gerbach

10:50 – 11:30 The Banking Crisis - Capitalism's Business as Usual PATRICK MINFORD (Cardiff University) Discussant: Sebastian Watzka (University of Munich) 11:30 – 12:10 What's Wrong with Modern Macroeconomics? Why its Critics Have Missed the Point MIKE WICKENS (York University) Discussant: Hans Dewachter (University of Leuven) 12:10 – 13:00 General Discussion

"Why the Renminbi has to Rise to Address Imbalances"

Martin Feldstein joins those arguing that China must let the value of the renminbi rise:

Why the renminbi has to rise to address imbalances, by Martin Feldstein, Commentary, Financial Times: Global leaders have agreed reducing global imbalances is a priority. ...[T]hat agreement means the US must raise its national saving to be less dependent on foreign funds. China must lift domestic spending to maintain high employment without producing so many exports.
Some progress is happening on both fronts. The US household savings rate has risen, driven by the need for US households to rebuild wealth. Corporate retained earnings have also begun to rise. But increasing private saving is not enough ... if federal deficits remain high. The Obama administration must agree a budget that will reduce deficits in the years ahead.
China has succeeded in raising its domestic spending through fiscal incentives and an explosive growth of credit. ... Chinese government spending has also increased domestic demand via major rises in infrastructure investment and building low income housing.
But while these two shifts are necessary to reduce global imbalances, they are not enough..., exchange rates must also adjust.
The dollar must decline relative to other currencies to make US products more attractive to foreign buyers and to cause Americans to substitute US goods and services for imports. ... That is why the recent decline in the dollar relative to the euro, the yen and other currencies is ... natural and desirable...
Unfortunately, the Chinese government has not allowed the renminbi to appreciate. ... With the dollar falling relative to other major currencies, the fixed exchange rate of the renminbi relative to the dollar has caused the Chinese currency to fall relative to the euro, yen and other currencies. The trade-weighted value of the renminbi has therefore been declining, making Chinese exports more attractive and foreign goods more expensive in China.
The result has been an increase in China's exports from $276bn in the second quarter of the current year to $325bn in the third quarter. This helps lift GDP and jobs in China but prevents reducing global imbalances.
China's policy of keeping the renminbi weak means that the US dollar must decline more rapidly against the euro, yen and other currencies to achieve the same overall trade-weighted fall of the dollar. China's weak renminbi policy therefore not only prevents remedying China's large current account surplus but also reduces Europe's exports. ...

Although China has agreed to take steps to reduce global imbalances and its trade surplus, it is reluctant to let its currency rise. ... Fortunately, the Chinese economy is expanding rapidly and its growth is becoming less dependent on exports. When it has the confidence to allow the renminbi to rise, we will be on the path to reduced global imbalances.

[Traveling: Scheduled to post at preset time.]

"Demystifying Social Knowledge"

Daniel Little looks at different approaches to "understanding society":

Demystifying social knowledge, by Daniel Little: There seem to be a couple of fundamentally different approaches to the problem of "understanding society." I'm not entirely happy with these labels, but perhaps "empiricist" and "critical" will suffice to characterize them. We might think of these as styles of sociological thinking. One emphasizes the ordinariness of the phenomena, and looks at the chief challenges of sociology as embracing the tasks of description, classification, and explanation. The other highlights the inherent obscurity of the social world, and conceives of sociology as an exercise in philosophical theory, involving the work of presenting, clarifying and critiquing texts and abstract philosophical ideas as well as specific social circumstances. The first approach looks at the task of social knowing as a fairly straightforward intellectual problem. It could be labeled "empiricist", or it could simply be called an application of ordinary common sense to the challenge of understanding the social world. It is grounded in the idea that the social world is fundamentally accessible to observation and causal discovery. The elements of the social world are ordinary and visible. There are puzzles, to be sure; but there are no mysteries. The social world is given as an object of study; it is partially orderly; and the challenge of sociology is to discover the causal processes that give rise to specific observed features of the social world. This approach begins in the ordinariness of the objects of social knowledge. We are interested in other people and how and why they behave, we are interested in the relationships and interactions they create, and we are interested in institutions and populations that individuals constitute. We have formulated a range of social concepts in terms of which we analyze and describe the social world and social behavior -- for example, "motive," "interest," "emotion," "aggressive," "cooperative," "patriotic," "state," "group," "ethnicity," "mobilization," "profession," "city," "religion." We know pretty much what we mean by these concepts; we can define them and relate them to ordinary observable behaviors and social formations. And when our attention shifts to larger-scale social entities (states, uprisings, empires, occupational groups), we find that we can observe many characteristics of each of these kinds of social phenomena. We also observe various patterns and regularities in behavior, institution, and entity that we would like to understand -- the ways in which people from different groups behave towards each other, the patterns of diffusion of information that exist along a transportation system, the features of conflicts among groups in various social settings. There are myriad interesting and visible social patterns which we would like to understand, and sociologists develop a descriptive and theoretical vocabulary in terms of which to describe and explain various kinds of social phenomena. In short, on this first approach, the social world is visible, and the task of the social scientist is simply to discover some of the observable and causal relations that obtain among social actors, actions, and composites. To be sure, there are hypothetical or theoretical beliefs we have about less observable features of the social world -- but we can relate these beliefs to expectations about more visible forms of social behavior and organization. If we refer to "social class" in an explanation, we can give a definition of what we mean ("position in the property system"), and we can give some open-ended statements about how "class" is expected to relate to observable social and political behavior. And concepts and theories for which we cannot give clear explication should be jettisoned; obscurity is a fatal defect in a theory. In short, the task of social science research on this approach is to discover some of the visible and observable characteristics of social behavior and entities, and to attempt to answer causal questions about these characteristics. This is a rough-and-ready empiricism about the social world. But there is another family of approaches to social understanding that looks quite different from this "empiricist" or commonsensical approach: critical theory, Marxist theory, feminist theory, Deleuzian sociology, Foucault's approach to history, the theory of dialectics, and post-modern social theory. These are each highly distinctive programs of understanding, and they are certainly different from each other in multiple ways. But they share a feature in common: they reject the idea that social facts are visible and unambiguous. Instead, they lead the theorist to try to uncover the hidden forces, meanings, and structures that are at work in the social world and that need to be brought to light through critical inquiry. Paul Ricoeur's phrase "the hermeneutics of suspicion" captures the flavor of the approach. (See Alison Scott-Baumann's Ricoeur and the Hermeneutics of Suspicion for discussion.) Neither our concepts nor our ordinary social observations are unproblematic. There is a deep and sometimes impenetrable difference between appearance and reality in the social realm, and it is the task of the social theorist (and social critic) to lay bare the underlying social realities. The social realities of power and deception help to explain the divergence between appearance and reality: a given set of social relations -- patriarchy, racism, homophobism, class exploitation -- give rise to systematically misleading social concepts and theories in ordinary observers. Marx's idea of the fetishism of commodities (link) illustrates the point of view taken by many of the theorists in this critical vein: what looks like a very ordinary social fact -- objects have use values and exchange values -- is revealed to mystify or conceal a more complex reality -- a set of relations of domination and control between bosses, workers, and consumers. With a very different background, a book like Gaston Bachelard's The Psychoanalysis of Fire makes a similar point: the appearance represented by behavior systematically conceals the underlying human reality or meaning. The word "critique" enters into most of Marx's titles -- for example, "Contribution to a Critique of Political Economy." And for Marx, the idea of critique is intended to bring forward a methodology of critical reading, unmasking the assumptions about the social world that are implicit in the theorizing of a particular author (Smith, Ricardo, Say, Quesnay). So Capital: Volume 1: A Critique of Political Economy is a book about the visible realities of capitalism, to be sure; but it is also a book intended to unmask both the deceptive appearances that capitalism presents and the erroneous assumptions that prior theorists have brought into their accounts. The concepts of ideology and false consciousness have a key role to play in this discussion about the visibility of social reality. And it turns out to be an ambiguous role. Here is a paragraph from Slavoj Zizek on the concept of ideology from Mapping Ideology:
These same examples of the actuality of the notion of ideology, however, also render clear the reasons why today one hastens to renounce the notion of ideology: does not the critique of ideology involve a privileged place, somehow exempted from the turmoils of social life, which enables some subject-agent to perceive the very hidden mechanism that regulates social visibility and non-visibility? Is not the claim that we can accede to this place the most obvious case of ideology? Consequently, with reference to today's state of epistemological reflection, is not the notion of ideology self-defeating? So why should we cling to a notion with such obviously outdated epistemological implications (the relationship of 'representation' between thought and reality, etc.)? Is not its utterly ambiguous and elusive character in itself a sufficient reason to abandon it? 'Ideology' can designate anything from a contemplative attitude that misrecognizes its dependence on social reality to an action-orientated set of beliefs, from the indispensable medium in which individuals live out their relations to a social structure to false ideas which legitimate a dominant political power. It seems to pop up precisely when we attempt to avoid it, while it fails to appear where one would clearly expect it to dwell.
Zizek is essentially going a step beyond either of the two positions mentioned above. The empiricist position says that we can perceive social reality. The critical position says that we have to discover reality through critical theorizing. And Zizek's position in this passage is essentially that there is no social reality; there are only a variety of texts. So we have one style that begins in ordinary observation, hypothesis-formation, deductive explanation, and an insistence on clarity of exposition; and another style that begins in a critical stance, a hermeneutic sensibility, and a confidence in purely philosophical reasoning. Jurgen Habermas draws attention to something like this distinction in his important text, On the Logic of the Social Sciences (1967), where he contrasts approaches to the social sciences originating in analytical philosophy of science with those originating in philosophical hermeneutics: "The analytic school dismisses the hermeneutic disciplines as prescientific, while the hermeneutic school considers the nomological sciences as characterized by a limited preunderstanding." (This text as well as several others discussed here are available at AAARG.) Habermas wants to help to overcome the gap between the two perspectives, and his own work actually illustrates the value of doing so. His exposition of abstract theoretical ideas is generally rigorous and intelligible, and he makes strenuous efforts to bring his theorizing into relationship to actual social observation and experience. A contemporary writer (philosopher? historian? sociologist of science?) is Bruno Latour, who falls generally in the critical zone of the distinction I've drawn here. An important recent work is Reassembling the Social: An Introduction to Actor-Network-Theory, in which he argues for a deep and critical re-reading of the ways we think the social -- the ways in which we attempt to create a social science. The book is deeply enmeshed in philosophical traditions, including especially Giles Deleuze's writings. The book describes "Actor-Network-Theory" and the theory of assemblages; and Latour argues that these theories provide a much better way of conceptualizing and knowing the social world. Here is an intriguing passage that invokes both themes of visibility and invisibility marking the way I've drawn the distinction between the two styles:
Like all sciences, sociology begins in wonder. The commotion might be registered in many different ways but it's always the paradoxical presence of something at once invisible yet tangible, taken for granted yet surprising, mundane but of baffling subtlety that triggers a passionate attempt to tame the wild beast of the social. 'We live in groups that seem firmly entrenched, and yet how is it that they transform so rapidly?' ... 'There is something invisible that weights on all of us that is more solid than steel and yet so incredibly labile.' ... It would be hard to find a social scientist not shaken by one or more of these bewildering statements. Are not these conundrums the source of our libido scindi? What pushes us to devote so much energy into unraveling them? (21)
What intrigues many readers of Latour's works is that he too seems to be working towards a coming-together of critical theory with empirical and historical testing of beliefs. He seems to have a genuine interest in the concrete empirical details of the workings of the sciences or the organization of a city; so he brings both the philosophical-theoretic perspective of the critical style along with the empirical-analytical goal of observational rigor of the analytic style. Also interesting, from a more "analytic-empiricist" perspective, are Andrew Abbott, Methods of Discovery: Heuristics for the Social Sciences, and Ian Shapiro, The Flight from Reality in the Human Sciences. Abbott directly addresses some of the contrasts mentioned here (chapter two); he puts the central assumption of my first style of thought in the formula, "social reality is measurable". And Shapiro argues for reconnecting the social sciences to practical, observable problems in the contemporary world; his book is a critique of the excessive formalism and model-building of some wings of contemporary political science.

My own sympathies are with the "analytic-empirical" approach. Positivism brings some additional assumptions that deserve fundamental criticism -- in particular, the idea that all phenomena are governed by nomothetic regularities, or the idea that the social sciences must strive for the same features of abstraction and generality that are characteristic of physics. But the central empiricist commitments -- fidelity to observation, rigorous reasoning, clear and logical exposition of concepts and theories, and subjection of hypotheses to the test of observation -- are fundamental requirements if we are to arrive at useful and justified social knowledge. What is intriguing is to pose the question: is there a productive way of bringing insights from both approaches together into a more adequate basis for understanding society?

[Traveling: Scheduled to post at preset time.]

"A New Approach to Gauging Inflation Expectations"

Good news for those worried about inflation: A new measure of inflation expectations indicates that "longer-term inflation expectations remain near historic lows, in the neighborhood of 2 percent":

A New Approach to Gauging Inflation Expectations, by Joseph G. Haubrich, Economic Commentary, FRB Cleveland: This Economic Commentary explains a relatively new method of uncovering inflation expectations, real interest rates, and an inflation-risk premium. It provides estimates of expected inflation from one month to 30 years, an estimate of the inflation-risk premium, and a measure of real interest rates, particularly a short (one-month) rate, which is not readily available from the TIPS market. Calculations using the method suggest that longer-term inflation expectations remain near historic lows. Furthermore, the inflation-risk premium is also low, which in the model means that inflation is not expected to deviate far from expectations.

Policymakers at the Federal Reserve and other central banks continually face the "Goldilocks" question—is monetary policy too tight, too loose, or just right? It would help if the central bank knew what real interest rates and expected inflation actually were, but these are not easy to observe. Visible indicators of these factors, such as Treasury inflation-protected securities (TIPS), survey measures of expected inflation, and nominal interest rates, are useful, but none of them alone quite tells the whole story. Nominal interest rates change with both real rates and expected inflation; survey measures ask about only a few horizons, and measures of inflation expectations coming from inflation-protected securities conflate expectations with risk premia. Uncovering a purer measure is possible, but it takes a careful combination of the available data and the application of economic theory.

This Economic Commentary explains a relatively new method of uncovering inflation expectations and real interest rates and describes what light those numbers can shed on the current status of the U.S. economy.

People's expectation of inflation enters into nearly every economic decision they make. It enters into large decisions: whether they can afford a mortgage payment on a new house, whether they strike for higher wages, how they invest their retirement funds. It also enters into the smaller decisions, that, in the aggregate, affect the entire economy: whether they wait for the milk to go on sale or buy it before the price goes up.

Real interest rates also play a key role in many economic decisions. When businesses invest—or don't—in plants and equipment, when families buy—or don't—a new car or dishwasher, they are making judgments about the real return on the object and the real cost of borrowing. As such, real interest rates can be an important guide to monetary policy. As Alan Greenspan once explained,1 keeping the real rate around its equilibrium level (which is determined by economic and financial conditions), has a "stabilizing effect on the economy" and it helps direct production "toward its long-term potential."

Modeling Interest Rates

For economists, a model is not a toy train or runway star, but rather, a simplified description of reality, usually involving equations. It's a way to describe how the parts of the world (or at least the financial markets) fit together. Our new approach to estimating inflation expectations starts with a model of real and nominal interest rates—in effect making assumptions and writing down equations that purport to describe how interest rates and inflation move over time.2 The model has two key parts. The first describes how short-term real interest rates and inflation move over time. The model has to capture movements of short-term rates accurately in order to describe the behavior of all interest rates accurately: If short-term rates rise, do they stay high or quickly fall; do they move smoothly or take a few big jumps? The second part of the model describes how those movements in short-term rates and inflation build up and determine longer-term interest rates and expectations.

Economists think longer-term rates such as 10-year bonds are tied to shorter rates in two ways, and the model reflects both. The first and most influential determinant of long-term rates is market expectations of future short rates. Investing in a two-year bond is a lot like investing in two one-year bonds back to back: one now and another one a year later. The yields shouldn't get too far out of line. But because those two investments are not quite identical, long-term rates are also determined in part by something else. Because of risk, because investors don't know what rates will be next year—longer-term bonds embed a term premium in their rates, a risk factor that makes long-term rates different from the average of expected future short rates.

This means that the model also has to describe how investors incorporate risk into interest rates. This has two parts. One has to do with capturing the amount of risk perceived to exist, which is in effect, capturing how variable short-term rates and inflation are, and the other has to do estimating the prices of those risks. These considerations introduce several new factors into the model including separate variability measures for inflation and interest rates, and, because investors might feel differently about variability in interest rates and inflation, separate prices of risk.

The model also needs to match two ways of looking at the data on interest rates and expectations of inflation. One is the "time series" way—how a specific interest or expected inflation rate varies over time. The other is the "cross-section" approach, which at any given date (say June 2, 1995) lists the "term structure" of rates at 1 month, 3 months, 1 year, and so forth. An accurate model matches both the time-series side (how rates change over time) and the cross-section side (the pattern of long and short rates at any given time). Put another way, the guess about how expected inflation moves over time must also be consistent with the relationship between long and short rates. For example, if inflation is very persistent, then seeing a high inflation rate today implies nominal long-term interest rates should also be high, as they embed the inflation that is expected to continue.

The next step is to "calibrate" the model, which involves tweaking some key numbers in the equations until the model produces results that match actual data. Some examples of these key numbers—parameters, in economists' jargon—for the time series side are numbers describing things like how variable and persistent short-term real rates and inflation expectations, and how large the price of risk is for both real rates and inflation. The calibration is done through a statistical analysis (in a rather complicated way we won't go into here). It's like calibrating a speedometer: once you measure the readings on a course you know, you can trust the reading in other situations.

In our case, the model gives predictions for nominal rates, and inflation expectations derived from inflation swaps, and the parameters are moved around until predictions look similar to the actual data. More specifically, the model tries to match the yields on Treasury securities from three months to 15 years. It matches expectations of inflation coming from three different sources: Blue Chip economic forecasts, which are short-term expectations of inflation over the next several quarters; the Survey of Professional Forecasters (SPF), which are opinions on inflation over the next ten years; and inflation swaps (a financial derivative in which investors swap a fixed payment for payments based on the CPI), which run the gamut from 1 to 30 years. Knowing there is a close match on rates we can observe, such as actual interest rates and inflation, we are more confident about what the model tells us about things that we can't observe, such as risk factors and expectations over horizons that the surveys did not ask about.


In a way, the story so far has been all about sharpening the knife. Now is the time to cut something with it. So what does the model tell us?

  • It provides estimates of expected inflation from one month to 30 years.
  • It provides an estimate of the inflation-risk premium.
  • It provides a measure of real interest rates, particularly a short (one-month) rate, not readily available from the TIPS market.

Expected Inflation

Figure 1 shows inflation expectations at an annual horizon from 3 months to 30 years. Despite a somewhat high one-month expectation of 4 percent, expectations rapidly return to the neighborhood of 2 percent, showing only a gradual increase after five years. In the short run, it is common for inflation to fluctuate, particularly since Blue Chip, the SPF, and inflation swaps base their expectations on the Consumer Price Index (CPI), not any of the more stable inflation measures such as the core, the median, or the trimmed-mean CPI. Big shifts in oil, gas, and food often lead to big month-to-month changes in the CPI, which often average out over the longer term. From the standpoint of the central bank, it is the longer-term trend that matters: Monetary policy determines inflation over the long haul, but it has little effect on price changes stemming from a poor harvest or a strike in the oil fields. Figure 1 shows that inflation expectations settle down after about two years; this suggests that the Federal Reserve still has credibility in keeping inflation low and that the massive increase in its balance sheet and the accompanying increase in banking system reserves has not served to unanchor the public's expectations of inflation.

Figure 1. Expected Inflation

Note: As of September 1, 2009. Source: Author's calculations.

Inflation-Risk Premium

A key advantage of using this model is the ability to split out inflation expectations from the inflation-risk premium. Figure 2 plots them both for the 10-year horizon. There are three things to note in this figure. First, it documents the long, slow effort to wring out inflation psychology from the public: It took about 20 years for inflation expectations to drop from over 6 percent to around 2 percent, where they have held roughly steady for the past six years. Implicit in this is the second point, that current expectations of longer-term inflation are near historically low levels, though up a bit from earlier this year. Finally, the inflation-risk premium is rather low and quite steady.

Figure 2. Ten-Year Expected Inflation and Inflation-Risk Premium, September 1, 2009

Note: As of September 1, 2009. Source: Haubrich, Pennachi, and Ritchken (2008).

Finding the inflation-risk premium is particularly important because it addresses the accuracy of the so-called "break-even" measures of inflation expectations ("break-even" because investors break even on their returns if inflation is as expected). These break-even rates come from financial markets, either as the difference between the interest rate on nominal Treasury bonds, which are not protected against inflation, and TIPS, which are, or from inflation swaps, where one party makes a fixed payment to receive a payment indexed to the CPI. The problem is that the break-even rate includes a risk premium. This risk premium means that the break-even rate overstates expected inflation and that changes in the break-even rate might arise from changes in the risk premium, not changes in expected inflation.

The inflation-risk premium averages around one-half of a percent for most of the period. It is also varies only between 29 and 61 basis points, effectively keeping between one-third and two-thirds of a percent over the 27-year period. Such a low and steady level means that outside of special periods, such as the present, break-even inflation rates provide a reasonable measure of expected inflation. The dominant portion of the break-even rate and by far the largest changes come from the expectations, not the risk premium. So in most instances, a change in the break-even rate can safely be attributed to a change in expectations. In the end, the model ends up supporting the case for using TIPS as a gauge of inflation expectations.

Short-Term Real Rate, September 1, 2009

TIPS provide a direct measure of real interest rates, but most TIPS are long-term, issued only in maturities of 5, 10, or 20 years. As time passes, of course, their time to maturity shortens, but even then they are not always traded very frequently. Our model, however, can produce (or estimate) short-term real rates. Knowing short-term real rates provides a crucial element in understanding monetary policy. Comparing actual real rates with a what Alan Greenspan above termed the equilibrium rate, sometimes also called the natural or neutral real interest rate—gives an idea of whether Fed policy is expansionary or contractionary. If the Fed sets rates so that the current real interest rate is above the natural rate, policy is contractionary, and if below, expansionary. If policy calls for tightness or ease, then rates must rise or fall. Of course, the natural rate can move around with changes in the economy, so the Fed may have to do quite a bit of raising and lowering just to stay neutral. Finding the real rate is also only half the battle, and probably the easier half at that: Policymakers also have to have some idea of what the equilibrium rate is.

A look at the short (one-month) interest rate from the model in figure 3 shows several things. Recently, the rate has been quite variable, swinging from a plus 7 to a minus 3 percent in 2009 alone, and it currently stands deep in negative territory. Overall, negative rates are uncommon, though not rare. They figure most prominently in the period from early 2002 to late 2004, a period when the Fed was worried about the possibility of deflation.

Figure 3. Real Interest Rate, September 1, 2009

Note: As of September 1, 2009. Source: Haubrich, Pennachi, and Ritchken (2008).


Financial markets provide a lot of information about the economy and expectations, but sometimes getting what you want takes a little bit of work. Our model, at the cost of some assumptions and complexity, splits out key components of interest rates, which individually often tell more about the economy than does the nominal interest rate alone.

Currently, the model indicates low rates, and stable inflation expectations. Although it is hard to estimate the equilibrium rate, the currently low level of the one-month real interest rate suggests monetary policy is reasonably accommodative. Despite this, our model provides some evidence that inflation is not expected to increase, as longer-term inflation expectations remain near historic lows, in the neighborhood of 2 percent. Furthermore, the low inflation-risk premium suggests people are reasonably confident that the dangers of inflation deviating far from their expectations are relatively low.


1. Testimony before the Subcommittee on Economic Growth and Credit Formation of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, July 20, 1993, p. 11.

2. Interested readers can find the details in "Estimating Real and Nominal Term Structures using Treasury Yields, Inflation, Inflation Forecasts, and Inflation Swap Rates," by J. Haubrich, G. Pennacchi, and P. Ritchken. Federal Reserve Bank of Cleveland, working paper, no. 08-10.

[Traveling: Preset to post automatically.]

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