Puzzles that assist in the economic analysis of real interest rates


To begin, let’s define the real interest rate, or more accurately a forward series of real interest rates. If the long rate is published at 6% for example, it is the nominal long rate. The real interest rate adjusts this figure for inflation, so if the inflation rate is 4%, then the real long rate is 6% minus 4%, or 2%.

However, almost everything beyond this simple definition of the real interest rate is murky.

During the 1990s, a series of tax increases and shifts in federal spending trajectories reduced the US budget deficit. The objectives were to restore fiscal prudence, lower real interest rates and stimulate private sector investment. It all seemed to work, and economists came away confident that they understood not only real interest rates, but many other things as well.

Alas, we did not. Since Bill Clinton’s presidency, the United States has run incredibly large budget deficits and racked up billions of dollars in public debt, including more recently covid-induced spending. Yet real interest rates continued to decline, often reaching negative territory, especially for short-term rates. The naive theory had predicted that they should increase.

The law of demand is one of the sacrosanct principles of economics: if the price of apples goes up, the demand for apples will go down. Yet when real interest rates rise, it is not clear that investment demand is falling, even if the numbers are adjusted for possible reasons why real interest rates might have changed in the first place.

This raises a deep question: if the law of demand does not apply, how well do we understand investment and real interest rates?

The puzzles deepen. There was a long-standing debate in economics about whether the US central bank, the US Federal Reserve, could use its monetary policy to influence real interest rates. After extensive research, the conclusion has been drawn that the US Fed can indeed have a marginal effect in providing more liquidity to the markets. Still, the effect is small enough that there can be plausible debate as to whether, statistically speaking, it exists.

These days, however, the real fed funds rate is below -4%, based on measures of underlying inflation. No one doubts that the US Fed’s monetary expansions, which have led to much higher inflation (almost 8% as last recorded), are a major factor in this change. In other words, the Fed’s impact on real rates is much more powerful today than in the past.

It’s even worse. Most observers did not anticipate that the expected short rates could fall and stay below -4%. Why hold these assets? I don’t have a good answer to this question.

Recently, the term structure of interest rates has reversed, meaning that short-term rates are higher than long-term rates. Economists have debated for decades whether such a sign could be a good predictor of a recession. (The theory is that low long-term rates mean that future investment demand will be weak, a bearish sign.) Still, current data sets are ambiguous. Thus, not only are real interest rates often difficult to predict, but they are generally not themselves clear predictive signals.

There are also international versions of these puzzles. Countries with high positive real interest rates have stronger real exchange rates than standard theory predicts. In terms of exchange rates, real interest rates are more powerful than one would expect, although in terms of investment, they are much less powerful. These puzzles remain unsolved.

It is a crucial question to know why there are so many enigmas around real interest rates. One view blames the way real rates are measured. For example, if each person faces a different rate of inflation, based on their own spending habits, the actual rates measured may not reflect the true actual rates that individuals face. Another possibility is that the very notion of interest rates is confusing to people, and the real challenge of incorporating the movement of future rates into their decision-making is even more confusing.

Yet, perhaps I should adjust my saying slightly: not all real interest rate propositions are wrong. It seems clear, for example, that US real rates have fallen significantly over the past century. But beyond that? If you hear the phrase “real interest rates,” take cover. Maybe even run the other way.

Tyler Cowen is a Bloomberg Opinion columnist and professor of economics at George Mason University.

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