Equilibrium interest rates - who knows what it is?

In the paper, Equilibrium Real Funds Rate: Past, Present and Future, by Hamilton, Harris, Hatzius, and West, we have our best empirical review of thinking on this rate complex issue. The combination of academic and Wall Street economists provides a very readable story on changes in equilibrium rates. This has become one of the most important issues in macroeconomics, monetary policy, and fixed income trading.  

Focusing on the fixed income trading issue, the equilibrium real rate is the foundation for any work on fair value bond asset allocation analysis. Simply put, if the equilibrium real rate is or should be 2%, we are looking at a rich bond market and allocations should be cut. If the equilibrium real rate is closer to zero, then we do not have a market that is rich. Billions in asset allocation flows rest on this question.  

Of course, this fixed income issue may seem trivial against the broader monetary policy issue. If the equilibrium real rate is at or close to zero, then waiting on any normalization make sense. If the rate is closer to the trend rate in GDP, it is time to start raising rates. This policy also ties back to what traders should do in the fixed income asset space. Normalization is going to be a slow process. 

The conclusions from the Hamilton study tell us there are no simple answer to what the equilibrium real rate should or has been. The lessons from history tell us any simple answer is a glib response to a complex problem. The authors go back in some cases to more than a hundred years of data across a wide set of countries to look for what should be considered the neutral rate of interest.

The uncertainty of what could be considered the equilibrium rate is very high. There is no easy rule of thumb and the link with then GDP is not strong. The equilibrium rate could be at the 2% pre-crisis consensus or it could be closer to zero. There is not enough evidence to say one way or the other. That said, the argument that we are in a secular stagnation is hard to agree to. The evidence associated with the real rate against the period of secular stagnation do not match. We do find that the equilibrium rate can change quickly and that growth can also change quickly once economic headwinds are removed.  However, the positive link between trend growth and real rates is weak. There is no long-term mean for the real rate and at best there is a mean-reversion to the world real rate which itself changes over time. These issues are only compounded by the problem of a zero bound; nevertheless, the evidence still point to a positive equilibrium real rate.

The policy conclusion from this strong group of economists is that "inertial" monetary policy is the wisest course of action. If we cannot predict or know the equilibrium rate, then a go-slow policy is prudent and thoughtful.