The Logic of the Negative Real Rates of the 1970’s

In the 1970’s, real interest rates went negative, as they are today. Is there any logic as to why they went negative way back when? Yes, there is…

In the course of a recovery from recession to boom, monetary policy will raise the real rate. The following graph plots the real rate (effective Fed rate minus CPI core inflation) with TFUR (total factor utilization rate, which is a composite measure for utilization of labor and capital. As the TFUR increases in a recovery, the real rate established by monetary policy will increase too.

You can see that the negative real rates are a logical extension of the up-sloping pattern. When the utilization of labor and capital was very low relative to the natural limit of the business cycle, real rates went negative.

The sensitivity of the real rate to changes in the TFUR is given by the slope of the trend line, 0.48 in the graph. This means that a change of 1% in the TFUR would be matched by a 0.48% change in the real rate.

So the negative real rates of the 1970’s are nothing unusual. But is there a model to explain the 0.48 slope of the trend line. Yes, there is…

My Effective Demand policy rule describes the path of the real rate as the TFUR changes given the parameters of the 1970’s. (dashed up-sloping blue line in following graph.)

The slope of the real rate path is given by its derivative (upper light blue line which uses the right axis). The slope of the real rate path ranges from 0.35 to 0.50 over the 1970’s normal range of the TFUR (70% to 85%). The slope of 0.48 in the first graph is expressed within the range expected by the ED policy rule.

The model here shows that real rates logically went negative as utilization of labor and capital decreased in relation to the natural limit of the business cycle. (Dashed blue line went negative at 77% TFUR in the 1970’s). Note: Currently though this same model does not prescribe negative real rates.