Bond Premiums and the Natural Real Rate of Interest
The natural real rate of interest—the level of the real federal funds rate most consistent with the Federal Reserve’s statutory mandates of maximum sustainable employment and stable prices—is a key guidepost for monetary policy decisions. But most approaches used to estimate the natural rate, also known as r*, have not kept pace with the Federal Open Market Committee’s rapidly expanding set of monetary policy tools. Craig S. Hakkio and A. Lee Smith introduce two approaches to estimating the natural real rate that account for the broad state of U.S. financial conditions as well as the additional accommodation that unconventional policies provide. Their results suggest bond premiums are an important determinant of the natural real rate of interest. Specifically, their estimates of r* from both approaches suggest a reduction in bond premiums increases the natural real rate.
Publication information: First Quarter 2017