Academic journal article Economic Review (Kansas City, MO)

Bond Premiums and the Natural Real Rate of Interest

Academic journal article Economic Review (Kansas City, MO)

Bond Premiums and the Natural Real Rate of Interest

Article excerpt

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 have not kept pace with the Federal Open Market Committee's (FOMC) rapidly expanding set of monetary policy tools. From 2008 to 2014, the FOMC purchased large amounts of Treasury and agency mortgage-backed securities to put downward pressure on longer-term interest rates and ease overall financial conditions. However, existing measures of the natural real rate, also known as r*, do not explicitly account for the additional accommodation these unconventional policies may provide.

In this article, we provide two estimates of the natural real rate that account for the Fed's balance sheet and, more generally, the broad state of U.S. financial conditions. Since the goal of the 2008-14 asset purchases was to ease financial market conditions by reducing bond yields, we use bond premiums to gauge the ease or tightness of financial markets. More specifically, we derive our first estimate of r* from a statistical model that explicitly incorporates term and risk premiums from bond markets. We then produce a second, purely data-driven estimate of r* by looking for a common component across multiple variables that have been plausibly linked to the natural rate, including bond premiums. While we construct these two estimates of r* quite differently, they yield similar results. Both estimates reveal that the natural rate reached historically low values during the 2007-09 financial crisis and recession but rebounded more recently as the economy improved and financial conditions eased.

Our results suggest bond premiums are an important determinant of the natural real rate and lead to highly cyclical estimates. In particular, our estimates from both approaches show that a reduction in bond premiums increases the natural real rate. All else equal, lower bond premiums can provide an additional source of policy accommodation by reducing financing costs for housing, consumer durables, and investment projects. Therefore, if the economy is operating at full employment and inflation rests at the FOMC's 2 percent longer-run objective, a change in bond premiums may require offsetting changes in the real federal funds rate to keep the economy on an even keel.

Section I motivates the inclusion of bond premiums in models of the natural real rate of interest and reviews the relationships between the Federal Reserve's balance sheet, bond premiums, and the natural rate. Section II presents a model-based estimate of r* that augments the popular Laubach and Williams model with bond premiums. Section III presents a purely data-driven approach for estimating r*. Section IV highlights how r* is related not only to the Federal Reserves balance sheet but also to other factors that shape global financial markets.

I. The Balance Sheet, Bond Premiums, and the Natural Real Rate

Assets held by the Federal Reserve increased from around $900 billion in 2007 to nearly $4.5 trillion in 2014. The balance sheet initially expanded during the financial crisis, when the Federal Reserve provided short-term liquidity to banks to fulfill its role as lender of last resort. However, the recession that followed proved too severe for conventional policy tools to address. To provide additional accommodation, the Fed began expanding its balance sheet further by purchasing substantial Treasury and agency mortgage-backed securities, a policy known as large-scale asset purchases or, more commonly, quantitative easing (QE). The last of three rounds of QE ended in October 2014, but the FOMC maintains a large portfolio of agency debt and Treasury securities by reinvesting proceeds of maturing securities. Consequently, the size and composition of the balance sheet continues to influence financial market conditions. …

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