Speech

Are Real Interest Rates Too High? MoneyMarketeersofNewYorkUniversity NewYork,NewYork September21,1999 As I travel around talking about mone- thetrendrateofinflation—inotherwords,the tary policy—sometimes in speeches realrateofinterestishigh.Forexample,the and sometimes with professional interestrateon1-yearU.S.Treasurysecuritiesis friendsinacasualsetting—acommon currentlyroughly5percent.Ifwetaketherecent question concerns my views about interest rates. inflationtrendofaround2percenttobeagood Of course, I always beg off when the question indicatoroftheoutlookforfutureinflation,then concernspossiblefutureFOMCactions;however, therealrateon1-yearT-billsisabout3percent. when the question concerns how I interpret the Thisrealratecompareswithanaverageinflationcurrentlevelofthereal,orinflation-adjusted,rate adjustedreturnon1-yearT-billsoflessthan2 of interest, I find the topic more congenial. In percentoverthepast50years.Similarly,thereal many cases, the “question” put to me is more a yieldonlongTreasuriesisabout4percenttoday, claimthanaquestion.Realinterestratesarehigh, whichisabout1percentagepointhigherthan so the argument goes, and the claim follows that typicalfortheU.S.economy. monetarypolicyisrestrictive.Thiseveninggives Somepointtothisobservationasevidence me an opportunity to discuss this issue with thatmonetarypolicyistootight—thattheFedis some care, and I think it safe to assume that the somehowforcingrealinterestratesupandchoking issue is of interest to this group. offeconomicgrowth.Inmyremarksthisevening, Beforeproceeding,Iwanttoemphasizethat I’dliketofocusonthepropositionthathighreal theviewsIexpressherearemineanddonot interestratesarenotaconstrainttogrowth,but necessarilyreflectofficialpositionsoftheFederal infactareaconsequenceofaneconomyinthe ReserveSystem.Ithankmycolleaguesatthe midstofarobustexpansion,withoptimistic FederalReserveBankofSt.Louis—especially prospectsforthefuture.Indeed,ifIweretotry MikePakko—fortheirassistanceandcomments, tobeprovocative,I’dsaythatIwishrealinterest butIretainfullresponsibilityforerrors. rateswereevenhighertodaythantheyare.I’dsay Giventhesensitivitiesandampleopportuni- thatbecauseofmyconvictionthataneconomy tiesformisinterpretationwheneveraFedofficial enjoyingevenfasterproductivitygrowthandeven discussesinterestrates,Iwanttobeabsolutely betteropportunitiesforprofitablebusinessinvestclearthatmyremarkstonighthavenothingtodo mentthanweseeintoday’seconomywouldbe withmyownpositiononshort-runmonetary characterizedbyahigherrealrateofinterestthan policy.Mytopictonightconcernstheaverage weseeinthemarkettoday. levelovertimeofthereal,orinflation-adjusted, Beforeanyonepullsoutacellphonetoreport rateofinterest.Iamnottalkingaboutthenominal that,“Pooleseesneedforhigherrates,”letme federalfundsrateforwhichtheFeddetermines saythatmychoiceofthistopictonightreflects anintendedrangeateachmeetingoftheFederal myfrustrationthatreportingaboutinterestrates OpenMarketCommittee. concentratesalmostexclusivelyonthesupply Viewedhistorically,nominalinterestratesin sideofthecreditmarket,whichtheFedinflutheUnitedStatesarehightodaycomparedwith ences,andneglectsthedemandsideofthecredit 1

ECONOMICGROWTH market,whichisdeterminedbyeconomicfunda- urementissuecloudsthepicture.Theindexed mentals.Mybasicmessageisthatallofusshould Treasuryissuestradeinfrequently,andsomepart craveanevenmorerobusteconomy,whichwould oftheirmeasuredyieldreflectstheirrelative inturnyieldanevenhigherrealrateofinterest, illiquidity.Inanyevent,toanalyzerealratesin thanwehaveseenoverthelastfewyears. historicalperspective,wehavetomakejudg- I’llproceedbyfirstoutliningafewmeasure- mentsaboutmeasurementsbeforetheindexed mentissuesbeforegettingintothemeatofmy Treasurybondswereavailableinthemarket. argument—thestateofinvestmentdemandand savingsupplyintheU.S.economyoverrecent years.I’llthenturntotheissueofinflationuncer- WHY SO HIGH? taintybeforeconcludingwithafewgeneralcom- Drawingonwhatwedoknowaboutitsbehavments.IhopethatIcanprovokeyouenoughto ior,ahighrealinterestrateisnotsomethingthat askafewquestionswhenIfinish. weshouldnecessarilyfear.Inthecurrenteconomicexpansion,characterizedbyahighrateof investmentspendingandthepotentialforrising HOW REAL IS THE REAL RATE? productivitygrowth,ahighrealinterestrateis Insomesense,theconventionineconomics exactlywhatweshouldexpect. ofreferringtoaninflation-adjustedinterestrate Thisobservationdoesnotmeanthatahigh asa“realinterestrate”ismisleading.Therealrate realrateissomethingweshouldstriveforor ofinterestisnotrealinthesensethatwecango embraceasamonetarypolicyobjective.The outandeasilyobserveittheeconomy.Certainly, inflationexpectationsbuiltintomarketinterest wecanmeasuretheinflation-adjustedreturn rates,howeverrational,arenotalwayscorrect.If thataninvestorreceivesafteradebtcontracthas atanygiventime,theinflationarypotentialofthe matured,butthisexpostmeasuretellsusonly monetarypolicyinplaceisnotfullyrecognized, howinflationhaserodedthereturnonaninvest- overlyexpansionarypolicymightbeassociated mentoversomepastperiod. withexcessdemandpressuresforgoodsandserv- Whenitcomestoanalyzingcurrenteconomic icesthatwouldputupwardpressureoninterest conditionsandevaluatingtheoutlookforthe rates,bothnominalandreal. future,amorerelevantmeasureoftherealinterest Interpretingtherealinterestrateisconserateisaforward-lookingmeasure.Sincethedeci- quentlyadifficultprospect.Butasweconsider sionsofsaversandinvestorsinaneconomyare thefactorsthatlikelyunderlieitsrecentbehavior, predicatedontheirexpectationsaboutthefuture, botheconomictheoryandrecenthistorysuggest itisthelevelofcurrentmarketinterestrates that,whilethereisgoodreasontomonitorthe adjustedforexpectedfutureinflation—theexante realrate’sbehaviorcloselyforindicationsabout realrateofinterest—thatmatters. theappropriatestanceofmonetarypolicy,its Measuringexpectations,ofcourse,isan currentlevelgiveslittlecauseforalarm. inherentlydifficultmatter.Wecanconductsur- Indeed,Iamconvincedthattherealrateof veys,estimatestatisticalmodels,drawinferences interestinthebondmarketishightodayforall fromeconomictheory,butwecannevermeasure therightreasons.Fundsinvestedinthebond preciselythepublic’sattitudeabouttheoutlook markethavetocompetewithfundsinvestedin forinflation.Infact,itispreciselythisprospect productivebusinesses.Weknowthatbusiness ofdisentanglinginflationexpectationsfrom investmentspendingisstrong;thatinrecentyears, observedmarketinterestratesthatmakesthe corporateearningshavegrownsmartly;thatthe evaluationofrealinterestratessochallenging. stockmarketvaluationsreflectconfidenceinthe Wearefortunatetodaytobeabletoobserve future;andthateconomywideproductivitygrowth yieldsonindexedbonds,butevenhere,ameas- hassurgedsince1995.Theseareallsignsofa 2

AreRealInterestRatesTooHigh? highreturnoninvestedcapital.Wehavealotto contributingfactortothelevelofrealinterestrates. celebrateinthiseconomy,andthehighrealrate Alowsavingratecanstraintheavailabilityof inthebondmarketreflectsthefundamentalswe loanablefundsintheeconomy.Theresulting celebrate. scarcityoffundsreinforcestheupwardpressure putonrealinterestratesbyrapidinvestment spending. INVESTMENT AND THE REAL RATE Indeed,savingrateshavefallenprecipitously overthepastfourorfiveyears.Thepersonal Oneofthemostdistinctivefeaturesofthe savingratedeclinedfromabout3.5percentin currenteconomicexpansionhasbeenthestrength 1994tonearzerooverthepastyear.Negative andpersistenceofinvestmentspending.In1998, personalsavingrateshaveevenbeenmeasured realfixedinvestmentrosetonearly17percent overthefirsttwoquartersof1999. asaproportionofGDP,surpassingrecentcyclical Ofcourse,measurementissuescropupin peaksofaround15percentandsettingarecord evaluatingthesavingrate:Savingiscalculated highforthepost-WorldWarIIperiod.Thisrate asaresidualfromthedataonpersonalincome ofinvestmentshowslittlesignofabating. andspending,andtheincomemeasureusedfor Therapidrateofinvestmentissurelyoneof thesecalculationsdoesnotincorporateunrealized themostimportantfactorsinexplaininghighreal capitalgains.Giventherecentrun-upofequity interestrates.Thefinancingofinvestmentspendvalues,theomissionofprospectivecapitalgains ingdrawsontheavailabilityofloanablefunds representsapotentiallyimportantfactorinthe intheeconomy.Asfirmscompeteforfundsto measurementofthesavingrate.Thesetechnical financetheirinvestmentprojects,risinginterest issuesaside,however,itseemsclearthatthe ratesserveasthekeymechanismbywhichcredit currentrateofsavingislowintheUnitedStates, marketsefficientlyallocateresourcestothemost particularlyatthisstageinamatureeconomic productiveventures. expansion. Evidencesuggeststhatthecurrentinvestment Economictheorytellsusthataspeoplemake boomisrelatedtotheadoptionofnewtechnolotheirconsumptionandsavingdecisionsoverthe giesininformationprocessingandtelecommubusinesscycle,weshouldexpecttoseesaving nication.Forexample,theshareofoverallfixed ratesriseoverthecourseofanexpansion.Inthe investmentspendingdevotedtoinformation earlystagesofanexpansion,pent-updemand processingequipmenthasrisensharplyinthe usuallygivesrisetorapidspendingandlow latterhalfofthe1990s,increasingfrom28percent saving.Nearthecyclepeak,however,thepace in1995tomorethan40percentsofarthisyear. ofspendingsubsides,andthesavingrateshould Asrapidinvestmentspendingcontributesto riseaspeoplesetasideahigherproportionof anupgradingofthenation’scapitalstock,the theirincomegainsasahedgeagainstleanertimes prospectsforrisingproductivityinthefutureare inthefuture. enhancedasnewtechnologiesareadaptedand Thispatternistypicalofwhatweusually integratedintoproductionprocesses.Ahighreal observeinthedataaswell.Thesavingratetends interestrateinthebondmarkettodayisaforecast tofallastheeconomyentersarecession,butthen ofproductivitygainsinthefuture.Isurelyhope risesastheeconomicrecoverymatures.Thedrathatforecastiscorrect. matic,sustaineddeclineinthesavingrateinthe late1990sissomewhatunusualinthisregardand representsanotherdistinguishingcharacteristic GROWTH, SAVING AND THE ofthecurrentexpansion. REAL RATE Oneexplanationforthecurrentpatternis Ontheothersideoftheledger,therecent thatpeopledonotforeseetheneedtosetaside declineintheU.S.savingratemaybeanother resourcesforthefuture.Perhapspeople’sexpecta- 3

ECONOMICGROWTH tionsforfuturegrowthhavebeenrevisedupward, SomefascinatingrecentresearchbyMartin andcurrenteconomicconditionsareseenmerely Evans,ofNYU,ontheexperienceoftheUnited asaforetasteoftheprosperitytocome. Kingdomduringthe1980shighlightstheimpor- Indeed,iftheslowdowninproductivity tanceofinflationriskinthedecompositionof growththatbeganinthe1970shastrulyturned marketratesintorealandexpectedinflationcomaround—asIandmanyothershavesuggested— ponents.EvansexaminesthebehaviorofU.K. thenalowsavingratewouldnotbesurprising. interestrates,comparingreturnsonBritain’s Correspondingly,arisinggrowthtrendforthe inflation-adjustedbondswiththoseofcomparable U.S.economywouldsuggestalastingriseinreal nominalbonds.Hisfindingsconfirmthoseof interestrates,sinceitistheunderlyinggrowth previousresearcherswhosuggestthatuncertainty rateofproductivitythatultimatelydetermines aboutfutureinflationgivesrisetoariskpremium boththeeconomy’sgrowthrateandtherateof inmarketratesonnominalbondsthatissignifirealreturnavailabletosaversandinvestors. cantandthatvariesovertime.Moreover,thisrisk AlthoughIwouldliketoseeahighersaving premiumappearstoberelatedtofearsofadrarateintheUnitedStates,myjudgmentisthatthe maticresurgenceofinflationthatisunlikelyto lowpersonalsavingratehaslittleornothingto occur,butwouldbedevastatingifitdid. dowiththeleveloftheU.S.realrateofinterest Concernsaboutsuchlow-probabilityevents today.Worldcapitalmarketsarehighlyintegrated, aremorelikelytobepresentineconomiesthat andtheflowofcapitalintotheUnitedStatesfrom havegonethroughrecentboutsofhighinflation. abroadislarge.Thus,inexplainingthelevelof Anecdotalevidencesuggeststhatsuchlingering U.S.realrateofinterest,Iputmyemphasison fearscanbeslowtodissipate.Forexample,many therobustU.S.economyandthetremendous astuteobservershavesuggestedthatthe investmentopportunitiesitoffers. Bundesbank’santi-inflationfervorsinceWorld WarII,andthepublicsupportforsuchpolicies, maywellberelatedtotheexperienceofGerman THE LINGERING LEGACY OF hyperinflationintheearly1920s! INFLATION Alongtheselines,therecentlyretireddirector ofresearchattheSt.LouisFed,WilliamDewald, Theforegoinganalysisofeconomicfundahasoftenarguedthatmeasuredrealinterestrates mentalsprovidesuswithsomeinsightintowhy constituteanindicatorofmonetarypolicycredirealinterestratesarehigh;moreover,itgives bility.Inparticular,hesuggeststhatcountries causeforoptimismaboutfutureprospectsfor withrelativelyhighmeasuredrealinterestrates theU.S.economy.Thereareotherreasonstobe arethoseinwhichconcernsaboutrisinginflation somewhatlesssanguine,however. Onedifficultyofdisentanglinginflationexpec- aremoreprevalent. tationsfromtherealinterestrateistheissueof IfmeasuredrealratesintheUnitedStates inflationuncertainty.Ariskpremiumassociated areindeedanindicatorofthistypeofinflation withthisuncertaintycouldcausemeasuredreal uncertainty,thenratescoulddeclineiftheFed ratestobehigh.Thatis,whenwesubtractreason- wereabletooffermoreclearassurancethatinflaableestimatesofexpectedinflationfrommarket tionwillnotresurfaceinthefuture.Publicopinion interestrates,weareleftwithameasurethatcom- andmarketsentiment,however,alreadyappear binesthetrue,underlyingrealrateandacompo- tograntagreatdealofcredibilitytotheFederal nentthatcompensatesfortheriskassociatedwith Reserve’scommitmenttokeepinginflationin uncertaintyaboutfutureinflation.Themeasured check. highrealrate—thenominalbondyieldless Minimizingtheprobabilityofunexpected expectedinflation—mightthereforereflectthe fluctuationsintheinflationratewillcontinueto lingeringlegacyofpastinflationandfearsthat beanimportantobjectiveofmonetarypolicy. thosedarkdaysmightreturn. Ultimately,theonlytruewaywewillbeableto 4

AreRealInterestRatesTooHigh? enhancecredibilityinthisregardisthroughsus- inflation.Ifwecaninferthatinformationfrom tainedhighperformance. measuresoftherealinterestrate,wewouldbe foolishtoignoreit.Butwemustalsorecognize thepotentialpitfallsofmisinterpretation. WHEN SHOULD WE WORRY? Anotherpotentialconcernaboutthelevelof CONCLUDING REMARKS realinterestratesisthepossibilitythathighrates arebeingdrivenbyunsustainableaggregate IhopethatIhaveconveyedtoyouboththe demandgrowth.Asstrangeasthismaysound, richnessoftheinformationcontainedinthereal estimatesofhighrealinterestratesmightindicate interestrate,aswellassomeoftheproblemsthat anoverlystimulativemonetarypolicystance— economistsandpolicymakersfaceintryingto onewithfutureinflationpotentialthathasyetto extractthatinformation.Researchonthemeasurebefullyrecognized. mentandinterpretationofrealrateswillundoubt- Marketexpectations,howeverrational,are edlycontinue,givingusgreaterclaritywithwhich notalwayscorrect.Ifhighmarketinterestrates toevaluatethesignalsabouttheeconomythat reflectoverlyrobustaggregatedemand,fueled areembeddedininterestrates. byanexcessivelystimulativemonetarypolicy, Asafinalcommentonthelevelofthereal thenahighrealinterestrate—conditionedonthe interestrateinrecentyears,I’dliketoagainview presumptionthatinflationwillremainincheck— ourcurrentsituationintheperspectiveofrecent mightbeanindicatorofincipientinflationary history.Therealratemaybesomewhathightoday, pressures. butnotsolongagoitwasnearzero.Realrates Theconfidencethatmarketshaveshownin werelowintheearly1990s,astheeconomy theFed’scommitmenttopricestabilityishearten- emergedonlysluggishlyfromtherecessionof ing,butifthatconfidenceturnsouttohavebeen 1990-91.Anevenmoresignificantperiodoflow misplaced,thegoaloflong-termpricestability realrateswasinthelate1970s,wheninflationwas willbeevenmoredifficulttoattain.Consequently, acceleratingandeconomicgrowthwasstagnant. akeychallengefacingmonetarypolicymakersis Giventhechoiceoflivinginaworldwith todeterminewhethertoday’sprovisionofliquid- lowrealinterestrates,reflectingsomecombinaitytotheeconomyisappropriateformaintaining tionofhighinflationandloweconomicgrowth, maximumsustainablegrowth(inanenvironment orlivinginaworldwithhighrealrates,reflectwherethatmaximumisuncertain)orwhetherit ingrapidgrowthandanoptimisticoutlookfor isfuelingunsustainableaggregatedemandgrowth thefuture,Ihavenoproblemindecidingwhich thatwillultimatelyleadtoinflation. worldtochoose.Idoubtthatanyofyouhavea Inmakingthatjudgment,weshouldtakein problemmakingthischoiceeither. accounteverythingweknowaboutexpectations regardingprospectsforeconomicgrowthand 5