Academic journal article Economic Inquiry

The Equilibrium Fed Funds Rate and the Indicator Properties of Term-Structure Spreads

Academic journal article Economic Inquiry

The Equilibrium Fed Funds Rate and the Indicator Properties of Term-Structure Spreads

Article excerpt

I. INTRODUCTION

Interest rate spreads figure prominently in the economics literature as monetary policy indicators. For instance, while some writers have focused on the predictive power of the spread between the six-month commercial paper rate and the six-month Treasury bill rate, others have emphasized spreads between short- and long-term interest rates.(1) This paper follows the latter tradition. My analysis is motivated by the work of Bernanke and Blinder [1992] who compare the difference between the federal funds rate and the ten-year government bond rate with other interest rate spreads and find it to be a particularly useful predictor of future economic activity.

The rationale for using term-structure spreads as monetary policy indicators is relatively straightforward.(2) When assessing the stance of monetary policy, it is not just the level of the federal funds rate that matters, but how it relates to some implicit notion of equilibrium interest rates. This insight is not new and can be found in the seminal work of Wicksell [1898, xxv] who wrote that "It is not a high or low rate of interest in the absolute sense which must be regarded as influencing demand...the causative factor is the current rate on loans as compared with what I shall be calling the natural rate of interest." The direct empirical implementation of the Wicksellian insight is, however, obviously hampered by the fact that the natural rate of interest is not an observable variable. As suggested by Laurent [1988] and Bernanke and Blinder [1992], the slope of the term-structure is often used as a proxy for the spread between a short-term interest rate and its (unobservable) equilibrium level. Thus, the yield curve steepens as short-term interest rates are perceived to be below their equilibrium levels.

I follow a more direct approach to measuring the stance of monetary policy. Instead of using the slope of the term structure as a proxy for the gap between observed and equilibrium federal funds rates, I introduce a model-based method to constructing a measure of the level of the equilibrium funds rate. As described below, this equilibrium rate is calculated for the real sectors of the economy, conditional on the observed rate of inflation. Thus, the equilibrium rate is constructed to be independent of the inflation objectives of monetary policy, and the implied difference between actual and equilibrium rates - the funds-rate spread constitutes my monetary policy indicator. This paper provides an overview of the proposed methodology and compares the funds-rate spread with traditional indicators of the monetary policy stance.

II. A MODEL-BASED MEASURE OF THE SPREAD

I rely on the estimated structure of a macroeconometric model to measure the equilibrium federal funds rate. The theoretical framework is the MIT-Penn-SSRC (MPS) model, which is housed at the Federal Reserve Board. This is a large-scale quarterly model of the U.S. economy; it consists of more than 100 behavioral equations, about 200 identities, and over 100 exogenous variables. In its theoretical foundations, the long-run properties of the model are akin to a neoclassical growth model, whereas the dynamic structure is essentially Keynesian.(3)

The approach used in this paper is a departure from the traditional literature in at least two dimensions. First, I use an explicit, theoretic framework to compute the equilibrium measure, as opposed to the empirically based approach of using long-term interest rates. Second, by focusing on the equilibrium level of the federal funds rate, I have a more direct way to gauge the stance of monetary policy.

The equilibria analyzed here correspond to intermediate-run dynamics, a time frame that seems most relevant for the conduct of monetary policy. Conceptually, the equilibrium notion I explore is a simple one. For a given position of the MPS model's IS block, the equilibrium federal funds rate is defined as the one consistent with unemployment at its natural rate after all lags in the model have fully worked through. …

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