A sustained increase in the deficit-to-income ratio is expected to raise real equilibrium rates, including the real neutral fund’s rate. Based on the empirical literature and the size of the fiscal impulse currently being implemented, we have raised our estimate of the real neutral fund’s rate by 25 basis points, from ¾% to 1%. As a result, the response of the fund’s rate to the fiscal stimulus has two parts: The first is an increase in the fund’s rate prescribed by simple policy rules in response to the decline in the unemployment rate and rise in the inflation rate. The second part is an increase in the fund’s rate to match the rise in the neutral fund’s rate. In our forecast and the accompanying rate projections, we have taken into account both the “leaning against the wind” response of monetary policy—raising the actual fund’s rate relative to the neutral fund’s rate—and the increase in the neutral rate. All told, the fund’s rate in our projection ends 2020 at a level that is 50 basis points above our upward-revised estimate of the neutral rate.
The Empirical Literature: The Effect of A Fiscal Impulse on Equilibrium Real Rates
Empirical studies of a sustained increase in the deficit-to-income ratio focus on the effect of expected sustained increases in that ratio on expected long-term interest rates.1 Laubach (2003) and Gale and Orszag (2004), for example, estimate that a sustained one-percentage-point increase in the expected deficit-to-GDP ratio raises the expected 10-year Treasury yield after five years by roughly 25 basis points.2 We are focused here on the impact of fiscal stimulus on the real neutral fund’s rate. An increase in the deficit-to-GDP ratio should raise real equilibrium rates across all maturities over which that ratio is expected to be higher, a percentage point for a percentage point. Therefore, based on the empirical estimates for the effect on longer-term rates, we have revised up our estimate of the real neutral fund’s rate by 25 basis points, from ¾% to 1%.
The Effect on Aggregate Demand
We measure the degree of monetary accommodation by the gap between the prevailing fund’s rate and the neutral rate. An increase in the fund’s rate relative to the neutral rate withdraws accommodation and leans against the increase in aggregate demand. On the other hand, a rise in the fund’s rate that matches an increase in the neutral rate does not alter that gap, and hence the degree of monetary accommodation.
1 The literature investigates the effects of both an increase in the deficit-to-income ratio and an increase in the debt-to-income ratio. Some of the work finds that, under plausible assumptions, the empirical results in each case are compatible.
2 Laubach, Thomas (2003). “New Evidence on the Interest Rate Effects of Budget Deficits and Debt,” Finance and Economics Discussion Series 2003-12. Washington: Board of Governors of the Federal Reserve System, April. The link is to May 2007 revised version. Gale, William G., and Peter R. Orszag (2004). “Budget Deficits, National Saving, and Interest Rates,” Brookings Papers on Economic Activity, 2004:2, 101-210.
FRB-US Simulations of the Effect of the Fiscal Stimulus
We informed our judgment about the effect of the fiscal stimulus on aggregate demand and the path of the fund’s rate using simulations with the Federal Reserve Board staff’s large-scale macroeconomic model, FRB US, incorporating a simple policy rule, one that Yellen refers to as the “balanced approach rule.” The integration of the fiscal stimulus into our forecast came in stages as our initial judgments about the size and composition of the fiscal stimulus were revised to match what was finally agreed upon. Taking into account the size of the fiscal stimulus, we raised our path for the fund’s rate through 2020 by 50 basis points, 25 basis points for the upward revision to our estimate of the real neutral fund’s rate, and 25 basis points relative to that upward-revised real neutral rate. That revised path has resulted in a projected funds rate at the end of 2020 that is 50 basis points above our upward-adjusted estimate of the neutral rate. We should note that the rise in the fund’s rate that is incorporated in our forecast is much shallower than would be called for by the policy rule we used in FRB-US. This reflects the fact we were reluctant to assume a pace of rate hikes faster than four per year, retaining a pace that could still be referred to as “gradual.” In our view, the FOMC will be wrestling with the balance between raising rates fast enough and far enough to contain the degree of overshoot of the 2% inflation objective and not raising rates so fast to the estimated neutral fund’s rate that the threat of recession becomes uncomfortably high, given that material overshoots of the neutral fund’s rate are typically followed by recessions (See Undershooting and Overshooting: Is This Time Different?).
When Will Participants Raise their Median Estimate of r-star?
We expect that the long and steady decline in participants’ median estimate of the “funds rate in the long run” is over. It may stabilize for a while, but we expect it to rise at some point, likely within the next few quarters. When it does, that rise should be reflected in an accompanying upward revision in the FOMC’s expected path of the fund’s rate.