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Market Commentary

Exploring Structural Change in

Interest Rates
July 2014

A Simple
Framework Offers
Insight into the
Neutral Rate

What is the neutral level of interest rates? Arguably, few other questions
may be so simply posed by an investor but prove so difficult to answer
convincingly. Determining the interest rate that should be consistent
with an economy operating at near-full capacity with close-to-target
inflation is of profound importance.
Wesley Phoa
Portfolio Manager
Los Angeles Office
20 years of experience (as of 12/31/13)
15 years of experience at Capital Group

Not only can knowledge of the neutral rate offer a guide to the likely
path of monetary policy, its a key driver of future bond returns, a
determinant of future liability returns (via discount rates) and even
influences expected equity returns.
Here, we develop an intuitive economic framework, identify the specific
drivers of the neutral interest rate and long-run U.S. Treasury yields,
and explore whether recent structural developments have prompted
fundamental changes.

Investments are not FDIC-insured, nor are

they deposits of or guaranteed by a bank
or any other entity, so they may lose value.

Market Commentary
Exploring Structural Change in
Interest Rates
July 2014

Key takeaways
There is good reason to believe
that the neutral levels of both
short-term interest rates and
Treasury yields are lower than
they were a decade ago though
not as low as some commentators
have recently suggested.
Since the financial crisis, estimates of neutral rates have a
wider (but still bounded) range of
Once the economy has reached
full employment, maintaining
a nominal federal funds target
rate of only 2% could be highly

The neutral rate is hotly debated

For a number of years most Federal Open
Market Committee (FOMC) members
seemed to believe that, in the long run,
the neutral federal funds target rate
should be about 4%.1 In other words, they
thought that a 4% interest rate would tend
to encourage economic growth consistent
with a zero output gap and stable
inflation; resources would not be underor over-utilized, and growth would neither
accelerate unsustainably (triggering an
inflationary spiral), nor decelerate and
become anemic.
Recently, however, the FOMC members
assessments of the policy rate consistent
with stable growth have looked less settled.
In the most recent Summary of Economic
Projections, the median projection of the
longer run fed funds rate was 3.75%, with
responses varying from 3.25% to 4.25%.
Whats more, this one-percentage-point
range probably understates the actual
uncertainty among FOMC members. Fed
Chair Janet Yellen noted during the June
18 FOMC press conference that members
had indicated uncertainty around their
individual responses.
The Fed isnt alone in revisiting the neutral
rate. More bond investors, academics and

Estimates of the neutral rate have

varied significantly in recent years.

central bankers have begun to question

how much the neutral rate has changed
in the post-financial-crisis world. With a
Fed rate hike likely in the not-too-distant
future, the lack of consensus around the
neutral rate is in sharp focus. In reality,
however, divergences between estimates
of the neutral rate have been evident ever
since the financial crisis struck in 2007.
Take a look at the chart, showing
econometric estimates published by
the San Francisco Fed and estimates
implied by bond market data. For most
of the 1990s and 2000s, the San Francisco
Feds estimate of the neutral rate over
the short run was in the 4% to 5% range.
Then, in 2008, it plummeted: the estimate
has stayed close to 2% for much of
the interim.
By comparison, the estimate of the longrun neutral rate imputed from the yields
of Treasury Inflation-Protected Securities
(TIPS) remained fairly stable until 2010.
Then, as TIPS investors came to expect
that a lower neutral rate would persist,
this estimate converged with the San
Francisco Feds. More recently, a higher
neutral rate is once again priced into
TIPS yields, while the other estimate has
remained historically low (see chart).

Estimates of the neutral federal funds rate

Estimated rate (%)


Market-implied estimate
(TIPS; medium- /long-run)

San Francisco Fed estimate


(econometric; short-run)















Source: Capital Group calculations; Laubach, Thomas, and John Williams. 2003. Measuring
the Natural Rate of Interest. The Review of Economics and Statistics 85(4) (November), pp.
10631070. Weise, Charles and Barbera, Robert, Minsky Meets Wicksell: Using the Wicksellian
Model to Understand the Twenty-First Century Business Cycle, in Macroeconomic Theory and
Macroeconomic Pedagogy (Giuseppe Fontana and Mark Setterfield, editors), Basingstoke and
New York, Palgrave Macmillan, 2009.

Market Commentary
Exploring Structural Change in
Interest Rates
July 2014

What is the neutral federal

funds rate? The neutral
rate can be thought of as
the policy rate that neither
stimulates nor restrains
economic growth.

Our simple economic framework, in

two steps
Ever since the pioneering work of Swedish
economist Knut Wicksell2 at the end of
the 19th century, many economists have
linked the question of the neutral rate
to the rate of economic growth and the
return on investments overall.
Guided by that Wicksellian approach,
we developed an intuitive economic
framework, from which we derived two
rules of thumb: one for determining
the neutral rate, the other for long-run
Treasury yields.
Armed with these two rules, investors can
begin to shed light on the factors that may
have prompted todays neutral rate and
long-run average Treasury yield to differ
from those of the past.
1. It takes a village to raise a short-term
interest rate
Imagine that we live in a barter
economy: a society with no money. You
are a village owner, with free rein over
all of the goods and services produced.
Want a new sword each day? Its yours.
Need a haircut for the village banquet?
No problem.
One day I visit from a neighboring
village. Admiring the sharpness of both
your blade and your hairstyle, I ask if
I could borrow the village for a few
weeks. Obviously, you want something
in return. What would be a fair
amount of interest (paid in goods and
services) for you to charge on this loan?
Clearly the interest you should charge
depends on your villages expected
production over and above the inputs
required, such as food, steel billets
and hairstyling products while I have
temporary ownership. If you agree to
less interest, I can borrow the village at
a rate that would allow me to profit. On
the other hand, if you demand a level
of interest that exceeds the villages
expected production, I would not be
inclined to borrow from you.

So in this simple world, the natural rate

of interest is determined by how much
the village can produce: its potential
output. Output may be affected by
both transitory and persistent factors.
For instance, if theres a flu outbreak,
nobody will be doing much work for a
couple of weeks, so not much will be
produced. In this case, the natural rate
is low, but only temporarily so.
If, however, theres an epidemic
involving a more grave illness, then
output could be affected for the long
run. Production may not fully recover,
and the fall in the natural rate of interest
could be permanent.
2. Show me the money
Now imagine that a convenient medium
of exchange money is introduced
into your village. All products and
services now have prices, so there can
be inflation or deflation. How much
money should you ask for if now you
want to be paid interest in money rather
than in kind?
In this instance the logical answer
would be a little different; the natural
money rate of interest is the money
value of what the village produces,
incorporating inflation (or deflation)
over the period of the loan, as well as
its output.
Next, lets add a further complication.
Suppose a second identical village
comes into your possession, and
you decide to sell one village and
deposit the money in the bank. How
much interest should your deposited
proceeds earn? At first glance, you
might think that you should demand
the same rate of return. But should
the interest rate you demand on your
money really be the same as the rate
you charged for lending me a village
that is worth the same amount of
money? The answer is no.
Assuming youre economically rational,
the rate of return you require from your
cash holdings should actually be lower

Market Commentary
Exploring Structural Change in
Interest Rates
July 2014

than the return you require from the

wealth you have via ownership of the
villages goods and services, because
holding cash provides other kinds
of benefits.
As well as being used for transactions,
cash has value as a buffer against
unexpected financial needs and
as a potential funding source for
unexpected investment opportunities.
Therefore, cash is able to fulfill a
role that an illiquid asset like a
village cannot.
Another part of this special value
of cash may also reflect reserve
requirements associated with financial
regulation of the villages. Suppose the
king tells you that because you still own
one village, you must hold a certain
amount of ready cash (to pay for repairs,
for example, in the event of a fire). Then
you have to keep some money in the
bank whether you want to or not. And,
as it is providing a service that it knows
you must use, the bank is able to pay
you less interest.

Rules of thumb for the neutral rate

and long-run Treasury yields
The lessons learned from all that
imaginary inter-village trading apply
equally well in the real world. We
therefore have our first rule of thumb,
which pertains to the neutral rate:
The neutral short-term interest rate is
determined, in the long run, by potential
output in real terms, the rate of inflation
or deflation and the special value of
holding cash.
This result can be extended to derive
a similar rule of thumb for longer term
interest rates that is, Treasury yields.
One key difference between short-term
and long-term rates is that the latter must
reflect uncertainty about returns.
If the future were certain, the yield on
a 10-year Treasury bond would be the
average of expected short-term interest

rates over the next decade, appropriately

weighted by present value. And our
expectations about these future short
rates should be largely determined by
the three factors listed in our first rule:
potential output, expected inflation and
the special value of cash.
In the real world, however, uncertainty
exists. Investors who are tying up their
money for 10 years require that the
yield they earn compensates them for
bearing the associated risks. Whats more,
Treasury securities, similar to cash, can
have their own special value. This leads
to three additional factors that influence
Treasury yields in the long run:
Inflation risk. Future inflation could
exceed current expectations if, for
example, monetary policy proves
ineffective or the official inflation
target changes.
Real duration risk. Real yields could
change due to unanticipated changes
in trend productivity,3 or the cost of
financing an external deficit could drive
up risk.
Special value of holding Treasuries.
Besides earning a rate of return,
Treasuries can be held as collateral,
enabling their owners to buy or sell
derivatives and potentially reduce risk
or generate gains. Furthermore, various
regulations require or incentivize banks
to hold Treasuries for capital adequacy
purposes. Part of the special value of
Treasuries, therefore, reflects the fact
that ownership of Treasuries is a necessary condition for some financial firms
to stay in business.
So, put it all together and we arrive at
our second rule of thumb for long-run
Treasury yields:
Treasury bond yields are determined, in
the long run, by potential output in real
terms, expected inflation, the special
value of cash, an inflation risk premium,
a real duration risk premium and the
special value of holding Treasuries.

Market Commentary
Exploring Structural Change in
Interest Rates
July 2014

Rules of thumb in hand, how is 2014

different from 2004?
We are now in a position to examine each
of the factors included in our two rules
and discern if recent structural changes
may have fundamentally changed the
levels of the neutral rate and long-run
Treasury yields.
Short-term interest rates 2004
versus today
To begin with, the recent histories of two
components of potential real economic
growth suggest that potential output
could have moved lower:
Labor force growth has declined more
rapidly than expected. The unanticipated shrinkage of labor force participation in the U.S. has amplified declines
that were already occurring due to the
gradual deceleration in the growth of
the working age population.
Productivity growth has disappointed,
but may pick up. By some measures,
productivity has been sluggish in comparison to past periods of economic
expansion.4 Still, short-term cyclicality
may be responsible, and our investment analysts findings at the company
level suggest its unlikely that a period
of long-term productivity stagnation is
upon us.
Meanwhile, changes in the inflation
outlook and the special value of holding
cash have also been evident:
The Feds inflation target may be
higher. In 2004, the market viewed
the Fed as having a tacit target of
1%2% in terms of core personal consumption expenditure (PCE) inflation.
Today, we know that the Feds target
is 2% headline PCE inflation over the
long run, which corresponds to a
slightly higher rate of inflation for the
headline Consumer Price Index (CPI).
Consequently, the Feds inflation
target is a little higher than it was a
decade ago.

The special value of cash may have

risen somewhat. One consequence
of more stringent banking regulations
(such as the Dodd-Frank Act and
Basel III) is that banks are required to
maintain more liquid balance sheets.
Separately, individual investors appear
more cautious than they were in 2004.
Surveys suggest that many Americans
have a diminished sense of job security
and believe they need more liquid savings to carry them through possible
spells of unemployment or reduced
hours. Consequently, liquidity has
become more prized.
Average Treasury yields 2004
versus today
Alongside the factors just discussed (in
regard to the short-term neutral rate),
there have been significant changes in
Treasury-related risk premiums and the
special value of holding Treasuries.
The inflation risk premium has
declined. Inflation seems to be lower
and more stable than it was a decade
ago. Inflation risk appears counterbalanced by a perceived rise in the risk of
deflation. Inflation shocks in the near
term appear unlikely. However, its
important to remember that inflation
risk has not gone away; in particular,
unconventional monetary policy and
its subsequent unwinding could have
unexpected consequences, including a
run-up in inflation further down the line.
Real duration risk appears stable,
but quantitative easing may have
suppressed the risk premium only
temporarily. Arguably this risk
premium should be higher. The
public debt-to-GDP ratio is greater
than it was a decade ago.5 An external
financial shock could therefore be
more costly. Yield risk has become
more asymmetric; the fact that bond
yields are lower may mean that upward
shocks are more likely than further
downward shocks.

Market Commentary
Exploring Structural Change in
Interest Rates
July 2014

The special value of holding Treasuries

has risen. New liquidity standards
and tighter regulation of derivatives
require that banks and other institutions hold more Treasuries. Similarly,
tougher regulatory capital standards
have enhanced the appeal of Treasury
holdings for banks. More broadly, the
level of geopolitical risk appears to be
elevated. Consequently, the value of a
safe-haven asset may be enhanced.

Three key initial insights are yielded

by our framework
In summary, the simple framework
developed here has yielded some
intriguing initial insights:

Our framework suggests that 4% may

still be a reasonable estimate of the longrun neutral nominal federal funds target
rate. However, by incorporating more
pessimistic assumptions, the estimate of
the neutral rate moves closer to 3%.
So, although our simple analytical
approach has resulted in a fairly
broad range of apparently reasonable
estimates of the neutral rate, there is a
clear implication for monetary policy:
Maintaining a nominal policy rate of
2% once the economy reaches full
employment could, in our view, be
highly inflationary.

Structural economic and regulatory

changes mean that estimates of the
short-term neutral rate and long-run
Treasury yields now entail a wider (but
bounded) range of uncertainty.
Research can shed light on changes
to the individual drivers of the neutral
rate within our simple framework. For
certain drivers (such as productivity
growth) forecasting requires industryby-industry analysis, and even insights
from a company perspective.
The neutral rate does appear lower
than it was 10 years ago, as do long-run
Treasury yields. Still, it appears that the
neutral rate remains significantly higher
than zero in real terms.

According to the periodic releases of FOMC economic projections.

Interest and Prices. A Study of the Causes Regulating the Value of Money (1936; translation of Wicksells original work, published in 1898: Geldzins
und Gterpreise. Eine Untersuchung ber die den Tauschwert des Geldes bestimmenden Ursachen.)
Trend productivity growth is the long-run rate of growth in total factor productivity economic output per unit of labor and capital input due to
long-term technological progress and improvements in efficiency.
For example, see historical nonfarm business real output data released by the Federal Reserve Bank of St. Louis available at http://research.
The Congressional Budget Office estimates that, as a percentage of gross domestic product (GDP), the federal debt held by the public will stand at
74% by the end of 2014; for most of the 2000s, the debt level was below 40%.

The statements expressed herein are informed opinions, are as of the date noted, and are subject to change at any time based on market or other
conditions. They reflect the view of an individual and may not reflect the views of others across the organization. This information is intended merely
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For financial professionals only. Not for use with the public.
Lit. No. ITGEFL-034-0714P Printed in USA CGD/CG/9866-S44779 2014 The Capital Group Companies, Inc.