Key Takeaways
- Assessing the “true” stance of monetary policy requires an estimate of the equilibrium rate of interest, otherwise known as r*. This is because the impact of any given level or change in policy rates can only really be understood by reference to r*.
We distinguish between short-term and long-term r*,
and show how short-term US r* seems to have moved
much higher following the pandemic.
This movement higher seems to have surprised the
Fed, and helps explain the large inflation overshoot in
the US. Real policy rates fell substantially below short-term
r*, exerting excessive stimulus to the economy.
Policy appears to have only become “truly” restrictive
around the middle of last year, when the real policy
rate finally exceeded short-term r*. We think the
current stance of policy and the timing that policy
became “truly” tight are broadly consistent with our
forecast for a US recession later this year.
Meanwhile, the factors that pin down long-term r*, are
unlikely to have moved significantly since the
pandemic. As such, the underlying drivers are likely to
be exerting downward pressure on policy rates over
time.
Short-term r* is also likely to fall as the recession we
forecast unfolds, which we think will eventually see
nominal policy rates decline substantially.