Last week I flew overnight from Cartagena, Colombia (90o F, very humid) to Jackson Hole, USA (37o F, plus wind chill). In both places I was asked a lot about monetary policy—by bankers at the conference in Colombia and by central bankers at the conference in the US. The most common question was “What is the real equilibrium policy interest rate?” Is it 2% as in the original Taylor rule, or is it 0%, (Taylor rule minus 2) as the people at PIMCO (Paul McCulley and Bill Gross) have been arguing, or is it even negative as the new secular stagnationists such as Larry Summers would have it.
FOMC members have expressed their views on this for a while, with a median of around 4% nominal, which translates into 2% real if you use their 2% target inflation rate. Recently their median is slightly lower, 3-3/4 %, and that is also what former governor Larry Meyer at Macroeconomic Advisers is saying, though this is still not much different from 4%.
Paul McCulley admits befuddlement by all this and is making the case for a change. In a recent PIMCO newsletter he says “…for me, it is so befuddling that the Fed, and thus the markets, still clings – even if reluctantly – to one man’s estimate of an “equilibrium” real fed funds rate, made in 1993: John Taylor, who assumed it to be 2%….I’ve got to hand it to John, whom I’ve known and liked for a very long time: Twenty-one years on, and you are still hardwired into the catechism of Fed policy!”
Well there are other plenty of other catechism type “questions-and-answers” that are not hardwired, though I wish they were, such as “Q: Should the Fed adopt and state a rule or strategy for the instruments of monetary policy? A:Yes”
I have not seen convincing evidence of a new neutral for the terminal federal funds rate in a policy rule. The 2 percent real rate was chosen back when the potential economic growth rate was estimated to be quite low (2.2% in my 1993 paper). Most important in my view is that the poor economic performance in the developed countries in the past few years is due to economic policy in general (which can change) not to some exogenously imposed “new neutral.” Also, when you ask monetary policy analysts in emerging market central banks around the world, they do not see evidence for such low equilibrium rates. For example, I learned in Colombia the real policy rate has averaged about 2 percent since inflation targeting began. My informal poll of emerging market central bankers at Jackson Hole revealed the same: two to three percent.
Of course, this debate centers on the real policy rate in the long run. There is more room for disagreement about the short run or the medium run, but for now the terminal rate of 4% still seems about right to me.