# Catching up to the Natural Real Rate

This is a comment on an article that came out yesterday called *The equilibrium real funds rate: Past, present and future* by James D. Hamilton, Ethan Harris, Jan Hatzius and Kenneth D. West. They talk about how difficult it is to determine an equilibrium real interest rate which is the real rate at full employment or the natural level of real GDP.

Yes, it would be difficult to estimate the natural real rate when one does not have an estimate of an effective demand limit for a business cycle. One has a vague idea what the output gap could be. It is like a blind person groping not knowing where a wall is.

My way to determine the effective demand limit may not be the best way, but it is the only way so far. No one else talks about one. So far the economy is following my theories. I hope to be opening some insights that economics has not seen before.

The authors of the referenced article say that the equilibrium real rate is somewhere between 0% and 2%. The wide range is based on uncertainty surrounding many factors. Based on the effective demand limit which sets the natural level of real GDP, I say the equilibrium real rate is in the upper range of their estimate, between 1.5% and 2.0%.

In the graph, I determine the natural real rate by first estimating potential real GDP with relation to an effective demand limit. (see this link) Then I take a 2-year, 3-year and 4-year annual growth rates of that potential real GDP. Then I average these 3 rates.

My sense though is that the authors agree with a natural real rate at least above 1.5% because they show a graph where the Fed rate normalizes a bit above 3.5%. This is based on an inflation target of 2.0% plus a natural real rate of 1.5%. It seems they expect the natural real rate to revert towards its mean.

However, this graph implies that the Fed rate could rise from 0.5% to 2.5% through 2016. In order to do this, the Fed rate would have to rise at least 0.5% every quarter after sitting at the ZLB since 2009. The markets would be shocked. The Fed seems too far behind the curve. Such a fast rate rise would be hard for the markets to stomach. But since the Fed does not see an effective demand limit, they estimate more available capacity than I and others do.

Interesting, but I have a nit-picky critique of your critique. I think the point of their Figure 4 graph is that if the “correct” path was the black line, then uncertainty would lead to a policy with lag and overshoot. They would agree with you that the gray line is suboptimal.

My thoughts are that the Fed will end up going slower than the current consensus (according to Tim Duy), of .25 every other meeting. The massive supply of workers who will reenter the workforce (or enter it for 19-26 year olds) when finding a good job becomes easier, will provide a huge damper on inflation and on further decreases in unemployment and it will be obvious in the data before 12 months.

Labor share won’t increase (or not much), but 150-200K new workers per month will keep GDP rising. By your model, does not effective demand increase if firms increase capacity simply because they see more population?

Arne,

You make a good point about their graph. But then, their graph would be terribly misleading. So I had to assume that the graph represented a real case scenario.

I hear you and Tim Duy. A slow rise is in order. Either way, the Fed rate is not likely to be able to normalize now. It is like a runner in a race who runs slow for too long trying to conserve energy. At some point, it will simply be impossible to catch the leaders who have been running faster. The Fed rate has lagged behind too long and won’t be able to normalize. The effective demand limit is way ahead of it… at least from my perspective.

In my model, effective demand increases if labor share increases in relation to the utilization of labor and capital. If firms increase capacity, thus lowering the utilization of labor and capital in relation to labor share, then yes, effective demand would increase.