Visualizing Historical Data for Interest Rate Paths
I have recently wrote 2 posts on a model for interest rates and inflation based on the Fisher equation…
Nominal rate = real rate + inflation
Here is the model that I will overlay actual data to below… (link to previous post)
The yellow star represents the Long-run natural target for normalized monetary policy at full employment… with a 2% inflation target and 2% natural real rate, which would give a 4% nominal rate. The Fed would like to achieve a 4% nominal Fed rate by full employment, but there is a possibility that they will only reach 3%.
The present location of the US economy is shown by the blue star. The goal would be to move the blue star directly to the yellow star as the economy reaches full employment.
Has the economy taken this direct path in the past? How did the Fed rate move toward its normalized rate at full employment?
Here is data for the 1960’s… (note: Sun symbol marks end of decade data.)
The path is mostly parallel to a constant inflation rate moving toward the Long-run normalized monetary target.
In the 1970’s, there were times of constant inflation moving toward a normalized monetary policy at full employment. There were also times where inflation grew in spite of rising nominal rates. At the end of the decade, the nominal rate, the real rate and inflation were all rising toward full employment.
In the 1980’s, Volcker set the real interest target over 5%, which brought down inflation. The paths were still many times parallel to constant inflation rates.
In the 1990’s, inflation was coming down. Yet, the path of interest rates during the business cycle was still to raise nominal rates and real rates together. There was momentum to overcome the rising real rates.
In the 2000’s until the ZLB, inflation was well-anchored. So the path of rates was direct toward normalized monetary policy at full employment.
We can see then that the suggested path by Paul Krugman of increasing inflation expectations would be very unusual historically.
Interesting stuff Edward. I’m not sure of the relevancy.
You speak of ‘real rates’ – but there is no such thing any longer. It’s going on 7 years where % rates have not been anything close to ‘real’.
What’s the ‘real’ rate today? About -1.5%. What’s real about that?
This isn’t just in the US, global % rates are set by CBs. When Japan buys $700B worth of bonds a year, you have to conclude that nothing is a real price or yield.
The business of CBs setting nominal yields in not going to stop anytime soon. Therefore the focus on real yields (that don’t exist) does not produce much in the way of forecasts. Garbage in – garbage out.
“Nominal rate = real rate + inflation”
It seems to be you need to add ‘for nominal rate 0’
If the reasons that banks still use the discount window have nothing to do with the mechanism that Fisher was describing, then the equation does not produce valid results. Instead, you have an indeterminate real rate.
Your blue star sits solidly inside an area which should be excluded. Do the wild charts of the 70s really say anything more than that inflation was not under control?
try that again
equation applies in the range: Nominal Rate > 0 AND real rate > 0.
Arne,
There is more to see in the 70’s. If you look in the 70’s, many times inflatiom was rising but real rates were not. The key to stopping inflation is to raise real rates.
And there is short run real rate that CB is trying to move with. The short run real rate moves toward the long run real rate as the economy expands in a business cycle. With that in mind, can you explain your modification to equation?
BKrasting,
I am with you. Interest rates seem sur-real. CBs really think that the short run real rate is below -1.5%. But they have continually mis-forecasted potential. It is confusing trying to really know where the “real” short run real rate is.
Lots of distortions in the economy. It’s as bad as how the volatility of high inflation hinders eeconomic growth.
“can you explain your modification to equation?”
It is just like saying the area is Pi * r^2 for r > 0. The result does not come from first principles if r<0.
Arne,
Why do you add that the real rate is greater than 0?
Edward,
Your graphs for the 1970s and the year 1980 are showing the dramatic effects of oil prices throughout that period.
See the inflation adjusted oil price per barrel for 1973 to 1980 here:
http://inflationdata.com/Inflation/Inflation_Rate/Historical_Oil_Prices_Table.asp
Note that between 1973 and 1980(inclusive) oil prices were increasing rapidly . After 1980 oil prices were doing down until 1986. (Very high but going down.)
Here is a my chart showing the percentage increases for Income, CPI-U, and Oil prices:
—–—–– Personal —–—–—- CPI-U —–—––– Oil
—––––– Income —–—–– Dec to Dec —– Price
Year — Increase —–—– Increase —– Increase
1972 —– 9.8% —–—–—–—- 3.4% —–—–––– -3.2%
1973 —- 11.2% —–—–—–—- 8.7% —–—–––– 23.2%
1974 —– 9.7% —–—–—–— 12.3% —–—–––– 78.4%
1975 —– 9.4% —–—–—–—– 6.9% —–—–––– 19.8%
1976 —– 9.6% —–—–—–—– 4.9% —–—–––– 1.5%
1977 —- 10.4% —–—–—–—- 6.7% —–—–––– 3.1%
1978 —- 12.4% —–—–—–— 9.0% —–—––– -3.4%
1979 —- 11.7% —–—–—–– 13.3% —–—–––– 49.4%
1980 —- 11.5% —–—–—–– 12.5% —–—–––– 32.7%
1981 —- 12.0% —–—–—–– 8.9% —–—––– -13.4%
1982 —– 7.0% —–—–—–—– 3.8% —–—––– -16.2%
1983 —– 6.9% —–—–—–—– 3.8% —–—––– -11.5%
1984 —- 10.5% —–—–—–—- 3.9% —–—–––- -5.2%
1985 —– 7.1% —–—–—–—– 3.8% —–—–––- -9.6%
1986 —– 6.0% —–—–—–—– 1.1% —–—––– -27.7%
“Why do you add that the real rate is greater than 0?”
If the direction of the equation is setting the nominal rate, then the equation should be applicable for valid values of the real rate. But loaners do not set a nominal rate based on their desire to make a negative real rate, so the equation does not describe a real world behavior for al values of real rate.
Of course, I am unconvinced that it describes the rate setting behavior of the central bank even for positive values of real rate.