For release on delivery
9:20 a.m. EDT (1:20 p.m. local time)
May 24, 2024
Some Thoughts on r*: Why Did It Fall and Will It Rise?
Remarks by
Christopher Waller
Member
Board of Governors of the Federal Reserve System
at the
Reykjavik Economic Conference
Reykjavik, Iceland
May 24, 2024
Thank you for the invitation to be here and speak to you today.1
I want to step away from shorter-term questions about the economic outlook and
monetary policy to delve into a subject of longer-term significance-r*. While there are
many concepts of r*, I interpret it to be the real policy interest rate that is neither
stimulating nor restricting economic activity with inflation anchored at the central bank's
inflation target. In the short term, policymakers must judge whether a given policy
setting is restrictive or otherwise, and while this judgment is made with some idea of r*, a
number of factors can influence the economy in the near term so that the current setting
of policy usually differs from the value of r*. At the same time, policymakers
continually update their view of the appropriate value of r*. Recently, for example,
discussions have focused on whether or not r* has risen, which has important
implications for the conduct of monetary policy.
For the purposes of this discussion, I am going to be talking about the long-run,
real value of r*, when inflation and employment have reached the Federal Open Market
Committee's (FOMC) goals. Because of that, an estimate of r* points toward where
monetary policy is headed over the longer run. This is important for policymakers
deciding the best way to get there and also for investors and other members of the public
who make decisions in the near term based on their expectations of future economic
conditions.
Much has been written on this topic, and different methods have been developed
to estimate r*. My goal today is not to debate which statistical estimate of r* is best but
rather describe what I believe are the economic factors behind the secular behavior of r*.
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In particular, I want to address two questions. First, what drove the decline in r* over the
past 40 years? Second, what are the factors that may cause it to rise? I am certain some
of you will disagree with my answers to these two questions, but that is the nature of
good intellectual debate and how we advance our understanding of the world around us.
One vital fact about r* is that it is a theoretical concept without any reliable and
straightforward way to determine its value. There are economic models that are used to
estimate the value of r* and also surveys of market participants or policymakers such as
the FOMC's Summary of Economic Projections. But r* is not a precise number, unlike
the unemployment rate, which can be measured directly. For these reasons, all of the
model and survey estimates come with large degrees of uncertainty.2 That's why we
always need to be humble in citing a numerical value for r*.
One thing that is evident from these different estimates, and additionally clear
based on the performance of the economy at different policy settings over the past couple
of decades, is that the value of r* changes over time.3 The change is slow moving, and I
tend to think of it as related to the movement in factors that we can see affecting the
economy over time. Though hard to precisely measure, having some understanding of
the current level of r* is a matter of obvious importance for monetary policy, so I will
focus today on factors that have contributed to the apparent decline in r* over the past
several decades and look at how they may influence its value going forward.
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To get some indication of how r* has evolved over time, it is helpful to look at the
real, or inflation-adjusted, yield of the 10-year Treasury security, the most widely held
safe and liquid asset. Let me pause here and explain why this is a good real-world proxy
for the theoretical value of r*.
Think of r* as the level of the real federal funds rate once all the cyclical ups and
downs of the economy have been factored out, including near-term policy tightening or
loosening that sometimes is necessary to move employment and inflation back to the
FOMC's goals. Someone buying or selling a 10-year Treasury security must determine
the appropriate price (or yield) by thinking about not only the near-term policy rate, but
also how the policy rate will evolve over the next 10 years. Thinking about the evolution
of the policy rate, most forecasts expect near-term shocks to die out and the economy to
move toward the FOMC's goals, so the policy rate-absent future shocks-will move
toward and eventually reach r*. This means the 10-year Treasury yield embeds a value
of r*. Since 10-year Treasury securities are widely traded, their price (and yield) is
reflective of current market views of the value of r*.4
With that stipulated, let's look at how the real yield on the 10-year Treasury
security has evolved. In figure 1, I plot two measures. One is a series starting in the
1980s using the nominal 10-year Treasury yield and subtracting out the Michigan
survey's view of expected inflation over the next 5 to 10 years (the solid black line). The
second measure is a market-based measure, Treasury Inflation-Protected Securities, or
TIPS, which started trading in the late 1990s (the red dashed line).
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These series clearly show a downward trend in the real yield of the 10-year
Treasury over most of the period, supporting the idea that r* declined over the past 30 to
40 years. Looking at the past few years, the two series show a recent increase. This is
the source of recent questions about whether r* has risen, which I will address later.
I want to pause here and show another measure of longer-term interest rates that
some people use to gauge the value of r*-the real return on capital. In my view, this is
not the appropriate interest rate to use for discussing r* because it includes some measure
of riskiness of business activity and is not directly related to the stance of monetary
policy. As you can see in figure 2, these accounting-based measures of the realized real
return on capital, as measured by the Bureau of Economic Analysis (the black line) or
researchers (the blue dashed line), do not show the longer-term downward trend that we
saw in the real 10-year Treasury yield. Also, these values have not necessarily moved up
in the recent past either. I look at these measures of the return on capital and conclude
that, unlike the 10-year Treasury, there is no secular decline in the real return to capital.
One could argue about how this private return is measured, but recent work, accounting
for a myriad of factors, finds only modest changes in this return.5
This divergence-the longer-term decline in the real 10-year government yield
until recently and the relatively flat real return on capital-holds across countries. Many
researchers have documented the decline in government yields around the world, so I will
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not here. Meanwhile, figure 3 shows a chart from a paper by Monge-Naranjo and others
where the median real return on capital (the white line) across countries has been roughly
steady since 1980.6 And, in fact, the blue region, which represents the dispersion of this
return across countries, has narrowed over the years.
To me, these data raise a very clear question: What are the factors or events that
have driven a wedge between these two rates of return, causing the real 10-year yield to
decline but the return on capital to be relatively constant? And what does this say about
r*?
Let me start by discussing what is not responsible for this difference in yields.7
First, it cannot be caused by longer-run trends in productivity. Trend productivity affects
the real return on capital first and foremost. So even if trend productivity growth was
falling over time, both rates of return would have fallen. But, clearly, the real return to
capital has not fallen over time. So falling productivity growth cannot be an explanation.
Second, this difference in yields cannot be the result of declining population
growth. Again, this would also lower the real return to capital since there are fewer
workers to use productive capital, which means the existing capital stock is underutilized,
thereby lowering its real return.
So, what drove the decline of the real return on government debt? It is obvious
that what makes U.S. government debt different from the real return on capital and other
interest rates is its safety and global liquidity. I will briefly discuss several factors that
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have influenced the supply and demand for safe, liquid assets. I will try to make the case
that the demand for safe, liquid assets outgrew the supply over the past 40 years, which
drove a secular increase in the price of U.S. Treasury securities and, thus, a secular
decline in their real yield. At the same time, the safety and liquidity of U.S. Treasury
securities was actually increasing, which made them even more attractive to global
investors.
To be clear, I am not focusing on day-to-day movements in interest rates from
idiosyncratic events that will ultimately unwind. Instead, I am thinking about factors that
have long-term consequences for short-term market interest rates and, hence, r*. I will
also consider how these factors may be influencing r*'s value today and in the future.
Let me first explain why I believe the safety of U.S. Treasury securities increased
over the past 40 years. By this I am not referring to default risk, which has been and will
be zero. By "safer" I mean greater stability in the real return from holding U.S.
Treasuries. I believe this occurred for two reasons. First, from 1980 to 2020 there was a
significant decline in the level and volatility of U.S. inflation. Second, the Great
Moderation during this period meant economic performance in the United States was less
volatile, which meant less variability in the monetary policy rate. This lowered the
interest rate risk from holding Treasuries. As a result, the opportunity to hold a default-
free asset with less risk of inflation and economic volatility made U.S. Treasuries more
attractive.
Support for this proposition comes from looking at the term premium on 10-year
Treasuries over the past 40 years, as is shown in figure 4. The term premium measures
the compensation investors must receive to accept risk from holding Treasuries. As you
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can see, there is a clear secular decline in the term premium on 10-year Treasuries. I
interpret this to mean that the inflation risk and real risk of holding Treasury securities
made them safer to hold as time went on.
Now let me turn to five factors that I believe played a role in causing the demand
for safe, liquid assets to grow faster than the supply of these assets, pushing down
Treasury yields and r*. Some of these factors are contributing to the downward trend in
U.S. longer-term rates, while others affect global longer-term interest rates more broadly.
The first factor is the liberalization and globalization of capital markets starting in
the 1990's. This increased the global demand for safe liquid assets to investors around
the world who previously did not have access to U.S. Treasuries. Financial and capital
markets and trade around the world were liberalized, and information technology saw
advances that aided the global movement of capital, which resulted in an explosion of
cross-border finance. For example, the share of external financial claims and external
financial liabilities as a share of annual global gross domestic product grew from around
100 percent in 1990 to over 400 percent today. That change reflects the fact that an
increasingly large share of the world's wealth is invested abroad, much of it in U.S. debt,
including Treasury securities. The rise in foreign official and private purchases of
Treasury securities resulted in an increase in the price of U.S. Treasury securities, driving
down yields.
The second factor causing demand for Treasury securities to grow more than
supply was the large buildup of official reserves that started after the reforms that
followed the 1998 financial crisis in Asia. One consequence of removing capital controls
and other financial market liberalization in other countries over the past 30 years has been
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to make foreign governments more vulnerable to sudden capital outflows and financial
crises. Many countries have responded by building up their foreign exchange reserves to
help weather such stress. Global foreign exchange reserves have increased from around
$1 trillion in the early 1990s to $12 trillion today.
Notwithstanding the drumbeat of warnings from some that the U.S. dollar is in
danger of losing its primacy in global trade and finance, it remains by a very large margin
the world's reserve currency. U.S. government debt, likewise, remains the primary form
of low-risk asset, which is reflected in the huge stock of Treasury securities held as
foreign exchange reserves around the world. The resulting demand for Treasury
securities has contributed to pushing down yields and, thus, lowering r*.
The third factor driving prices up and yields down for Treasuries and similarly
affecting r* is sovereign wealth funds. In addition to foreign exchange reserve holdings,
sovereign wealth funds from some economies, especially those rich in natural resources,
have become an increasingly important way for governments to invest abroad and
diversify their national wealth. They are an increasingly significant force in global
financial markets. Although sovereign wealth funds are diverse in their holdings, U.S.
government debt is typically a sizable share of these funds. Sovereign wealth funds have
grown from $1 trillion in assets in 2000 to $11 trillion last year, and a lot of those assets
are presumably in U.S. Treasuries. For example, Norway's sovereign wealth fund
holdings of Treasuries grew from $5.6 billion to $132.4 billion over this period.8 The
growth in Treasury holdings by sovereign wealth funds has clearly contributed to the
decline in Treasury yields.
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The fourth factor that is thought to have influenced Treasury yields and r* over
the past couple of decades is the aging of the population in the United States and around
the world. The argument here is that as people move past their prime working years,
their demand increases for safe, liquid investments that ensure their principal is preserved
for their needs in retirement. U.S. Treasuries fill this need. Aging has been driven by the
fact that Americans are living longer, and another big factor has been the aging of the
large baby-boom generation, born between 1946 and 1964. The share of the U.S.
population aged 65 or older has increased from 12 percent in 1990 to 17 percent today,
which is 1 in 6 people. There is evidence that the large number of baby boomers who are
retired or planning to do so soon has boosted demand for Treasury securities.9 Outside
the United States, population aging is accelerating even faster.
The fifth factor that increased the demand for Treasuries came from many new
financial regulations implemented after the 2008 global financial crisis. Regulators in the
United States and abroad increasingly wanted banks to hold safer and more liquid assets
as part of their balance sheets. For example, the implementation of the Liquidity
Coverage Ratio requirement for larger financial institutions in the United States considers
Treasury securities preferable to other liquid assets such as mortgage agency debt and
mortgage-backed securities. This rule has boosted demand for Treasuries. In the years
leading up to the deadline for compliance with the rule, Treasury holdings by large banks
increased notably.10 Regulators have also focused on the safety and liquidity of U.S.
money market mutual funds, and there has been a dramatic shift in this industry away
from prime money funds, which hold private debt instruments, to government money
funds that hold U.S. Treasury debt obligations. Thus, we saw a significant increase in
regulatory-driven demand for safe, liquid U.S. Treasuries over the past 15 years. On top
of this, the Federal Reserve shifted from a limited- to ample-reserves regime to
implement monetary policy effectively at the onset of the Global Financial Crisis.11 This
regime shift resulted in more Treasury securities permanently held by the Federal
Reserve. These policy choices have resulted in higher demand from the public and the
Federal Reserve and put downward pressure on yields and r*.
As I mentioned earlier, there has been a lot of debate during the past year as to
whether or not r* has increased. If you believe the narrative I have just provided as to
what drove down r* over the past 40 years, one must ask which of those factors have
reversed. I do not believe any of these factors can explain the possible recent increase in
r*, but some may conceivably be a contributing factor to an increase in r* in the future.
Let's consider each factor. First, demographics are such that between 2015 and
2050 the proportion of the world's population over 60 will nearly double from 12 percent
to 22 percent. This will continue to put downward, not upward, pressure on r*.
Second, is it possible for liberalization of capital markets to reverse due to
increased geopolitical frictions? Possibly, but not yet to any significant degree.
Third, is it likely that central banks and sovereign wealth funds around the world
will dramatically decrease their holdings of U.S. Treasuries? Not likely, although the
growth in their demand may slow. As I have argued more extensively elsewhere, I do not
expect the dollar to lose its status or influence anytime soon, and recent developments, if
anything, point more to increased influence for the dollar than to any significant
decline.12 On top of this, I don't expect other countries to emerge as substantive issuers
of safe and liquid assets to rival Treasuries as an investment, nor any change in the
approach of the countries with sovereign wealth funds that would lead them to pull back
from their foreign investments.
Finally, is it possible that regulatory pressures forcing financial institutions to
hold more safe and liquid government debt will recede and raise r*? The current
regulations are likely here to stay, and banks are compliant with the rules. So the growth
in regulatory demand for Treasury securities could slow (not increase) substantially. Of
course, as financial innovation occurs regulations evolve, so we should watch how this
factor as well as all the others can affect r* in the future.
Let's now turn our attention to the supply of Treasury securities and ask if this
can possibly explain why r* may be increasing now or in the future. The U.S.
government issues Treasuries to finance deficit spending, which obviously impacts
Treasury supply. Deficit spending and the federal debt have been increasing since the
1990s. I believe the factors increasing demand that I just reviewed have outstripped the
increase in supply over the past few decades, leaving r* lower. But if the growth in the
supply of U.S. Treasuries begins to outstrip demand, this will mean lower prices and
higher yields, which will put upward pressure on r*.
It is probably not news to many people that the U.S. is on an unsustainable fiscal
path.13 The latest outlook from the Congressional Budget Office paints a challenging
picture of the future, with debt expected to grow at an unprecedentedly high rate for an
economy at full employment and not involved in a major war.14
All of these financing pressures may contribute to a rise in r* in coming years, but
only time will tell how large a factor the U.S. fiscal position will be in affecting r*.
Looking ahead, as a policymaker, it is important to understand what is driving any
movement in r* to justify using it to guide my policy deliberations. One cannot simply
claim r* has risen based on gut feelings-there must be a reasonable economic
explanation for why it has risen or fallen. My objective here today was to provide some
arguments for what has moved r* over the past several decades and what could move it in
the future.
Some Thoughts on r*: Why Did it
Fall and Will it Rise?
Christopher Waller
Member
Board of Governors of the Federal Reserve System
Delivered at the Reykjavik Economic Conference
Reykjavik, Iceland


Figure 3. Marginal product of physical capital across countries
capital
physical
of
product
Marginal
Note: White line represents the median; blue shaded areas from the proximity to the median out show the 25th to 75th
percentile range, the 10th to 90th percentile range, and the 5th to 95th percentile range.
Source: Alexander Monge-Naranjo; Juan M. Sánchez; Raül Santaeulàlia-Llopis (2019), "Natural Resources and Global
Misallocation," American Economic Journal: Macroeconomics, vol. 11 (April), pp. 79-126.