Real rates are currently negative. (0.2% Fed rate minus 1.6% core inflation) Yet the natural real rate is estimated to be around +1.6% due to positive population growth and positive productivity growth. Normally the real rate returns to its natural level. Will the real rate rise to its natural level in this business cycle?
Real rates went negative in the 1970’s, but even then they returned to their natural level by the end of the business cycles.
The graph shows the path of real rates (effective Fed rate minus CPI core inflation) through the 1970’s. The red dashed line is the path of real rates prescribed by my effective demand policy rule. The black circle shows the natural level of the real rate, 3% at full employment.
Effective Demand real rate rule = z*(TFUR2 + ELS2) – (1 – z)*(TFUR + ELS)
z = (2*ELS + NR)/(2*(ELS2 + ELS))
TFUR = Total Factor Utilization Rate, (capacity utilization * (1 – unemployment rate)).
ELS = Effective Labor Share is Non-farm Labor Share: Business sector * 0.765. Equation for ELS = (7.5*previous quarter ELS + 2.5*2 quarters previous ELS)/10
NR = Natural real rate of interest of 3.0%. See highlighted in yellow at top of graph.
LRAS curve = ELS limit.
In the graph, after real rates went negative, they eventually returned to their natural rate which is what they are supposed to do.
Here is the graph for the 20 years between 1987 to 2007…
Again we see that the real rate returned to its natural level of 3% at the natural limit of the business cycles. The real rate actually went negative many times during those 20 years.
Now the graph for the current situation…
The plot of the real rate has not quite returned to the LRAS curve which has declined to 75% due to the unusual fall in labor share since the crisis. The black circle shows where the estimated natural point for the real rate is. There is simply no way the Federal Reserve will be able to raise the real rate to its natural point. The rise now would be too drastic.
The real rate looked as though it was going to trend back to its path by the end of 2010. Remember the green shoots. But then the Federal Reserve proclaimed the Fed funds rate would stay low for a long time. Many actually believed back then that the Fed rate would rise like in times previous. But it didn’t and the real rate has been held down below its prescribed path since 2011. The real rate is even below the path in the first graph for the 1970’s. Wow!
The real rate will not be returning to its natural level in this business cycle. Strange days indeed.