roger w ferguson, jr : equilibrium real interest rate - theory and application remarks by mr roger w ferguson, jr, vice - chairman of the board of governors of the us federal reserve system, to the university of connecticut school of business graduate learning center and the ss & c technologies financial accelerator, hartford, 29 october 2004. * * * i want to thank the university of connecticut for providing me this opportunity to comment on the important and challenging concept of the equilibrium real interest rate and its relevance to monetary policy. i will use this occasion to discuss the role that estimates of the equilibrium real federal funds rate can play in thinking about the desired degree of policy accommodation. those views, i should add, are my own and are not necessarily shared by anyone else in the federal reserve system. i hope that at the end of this talk you will conclude, as i do, that while the concept of the equilibrium real rate is a useful aid in thinking about setting monetary policy, it is not measured and observed with such precision as to provide a practical guide to the appropriate stance of policy. current situation as the most recent statement of the federal open market committee ( fomc ) made clear, the u. s. economy appears to have moved out of the soft patch that characterized the second quarter. supported by ongoing advances in productivity and the attendant increases in real incomes, household spending has picked up. businesses, for their part, seem to have shaken off at least some of their hesitancy to spend, although the subdued pace of hiring may signal that they still retain a wary attitude toward making important commitments. but the strengthened balance sheets of the business sector, along with buoyant cash flow, should provide firms with the wherewithal to fund a healthy expansion of the capital stock in coming quarters. no doubt the recent run - up in energy prices poses some challenges, but the evidence indicates that, without some further material shock, aggregate demand is on a track consistent with sustained economic growth. that should gradually return the economy to full utilization of its resources, while inflation remains subdued. the fomc was confident enough about its assessment of the vigor of spending to indicate in its most recent statement that it continues to believe that policy accommodation can be removed at a pace that is likely to be measured. that begs the question, of course, of how the committee can be sure that policy is currently accommodative. i find it instructive to first consider how not to measure policy accommodation. in particular,

frb / us, to calculate at any point in time the level of the real rate that would eliminate economic slack in a reasonable period of time. or we can rely on a reduced - form description of the economy that measures the output gap in terms of the actual real short rate. the value of the real rate that will move that gap to zero can be thought of as the equilibrium real rate. besides the assumptions undergirding the construction of either model, such a calculation will require judgment in determining what is a “ reasonable ” period of time and how to cope with the run of prediction errors that are inevitable when trying to explain economic data. an attempt to employ a large model to calculate the equilibrium nominal federal funds rate can be found in an article by antulio bomfim. 1 using the mps model, the predecessor to the board staff ’ s current model, bomfim found that the equilibrium nominal funds rate varied in a range from 2 percent to 14 percent over the period from 1965 to 1994, implying that his estimate of the equilibrium real rate turned negative at times. laubach and williams opted for the single - equation approach and estimated that the equilibrium real funds rate was around 3 percent in mid - 2002 but that it varied from as low as 1 percent in the early 1990s to as high as 5 percent in the late 1960s. 2 in addition to exhibiting large swings, the laubach - williams point estimate of the equilibrium rate is a very uncertain statistic. the confidence interval around the estimate is such that there was a 70 percent probability that the actual value of the equilibrium real rate was between 0. 5 percent and 5. 5 percent. clearly, this estimate is not measured sufficiently precisely to be a useful guide to policy. an alternative approach turns to financial markets to infer the market ’ s assessment of the longer - term prospects for real interest rates. since 1997, the u. s. treasury has been issuing price - index - linked securities providing an assured real return. with about $ 250 billion of these inflation - protected securities now outstanding, we can get readings along the entire maturity structure of real interest rates. currently, for instance, real short yields are close to zero, and longer - term rates are at about 1 - 5 / 8 percent. one could presume that the forward real rate of interest implied by yields on longerterm indexed debt - or the real return provided, say, over the period five to ten years from now conveys a sense of market