Sylvain Leduc and Glenn Rudebusch of the Federal Reserve Bank of San Francisco.
The aging of the labor force, weak productivity growth, and possible long-run supply-side damage from the Great Recession have all suggested recently that the potential growth rate of the U.S. economy may be lower in the years ahead. According to standard economic theory, such slower growth would push down the level of the natural rate of interest. This natural rate, also called the neutral or equilibrium real interest rate, is the risk-free short-term interest rate adjusted for inflation that would prevail in normal times with full employment (Williams 2003).
Moreover, a decline in the natural rate of interest would tend to lower every other real and nominal interest rate in the economy. Therefore, understanding the linkage between economic growth and the natural rate is crucial for forecasting all types of interest rates. Indeed, this linkage has been at the center of recent fiscal and monetary policy forecasts. The Congressional Budget Office (CBO 2014) noted that its lower projections of U.S. Treasury yields and the federal government’s future debt servicing costs partly reflected reductions in its forecast for potential output. In addition, earlier this year, some Federal Open Market Committee (FOMC) participants appeared to reduce their estimates of the natural rate of interest because of an expectation of slower growth ahead for potential output.
This Economic Letter examines the linkage between growth and interest rates as embodied in recent projections by FOMC participants, the CBO, and private-sector forecasters. Although forecasts of potential growth or the natural rate are rarely reported, we can construct reasonable proxies from long-run forecasts of GDP growth, the short-term interest rate, and inflation. In essence, the long-run nature of these forecasts strips out cyclical variation and reveals the fundamental secular trends that underlie the concepts of potential growth and the natural rate of interest.
Although in the CBO and FOMC policy projections long-run forecasts of growth and the real interest rate have fallen together, private-sector forecasters do not anticipate a similar dual drop. In particular, the recent downward revisions in private-sector expectations for long-run growth have been associated with no change in their long-run projections of the real short-term interest rate. If the private-sector forecasters are correct, this would raise a concern that the CBO and FOMC may have overestimated the effects of slower potential growth toward reducing interest rates, which may introduce some upside risk to CBO and FOMC interest rate projections. ...
Skipping to the conclusions:
In this Letter, we document a range of views about the link between potential growth and the natural interest rate. In particular, while the CBO and many FOMC participants expect weaker long-run growth to translate into lower interest rates, private-sector forecasts do not seem to share this view. Thus, future downward pressure on interest rates may be more muted than indicated by current monetary and fiscal policy projections, which would translate into an upside risk to these longer-term interest rate forecasts.