Ruled by a “phantom rate”

That is implied by this Gavyn Davies piece “Who is right about the equilibrium interest rate?”:

The equilibrium real interest rate continues to lie at the heart of discussions about economic policy in the US and elsewhereBen Bernanke has written that the equilibrium rate, and not the FOMC, is the ultimate determinant of interest rates in the economy, and claims that it is discussed at every Fed meeting. The recent debate about secular stagnation between Mr Bernanke and Lawrence Summers centres on a difference about the future path for the equilibrium rate. And Cleveland Fed President Loretta Mester says that it is “the issue policy makers are grappling with” at the FOMC.


If, for example, the Fed sets short rates higher than equilibrium, the economy will respond by generating a rise in unemployment and inflation will fall below target. And vice versa. Mr Bernanke believes that the equilibrium real rate is currently abnormally low, but that it will rise gradually in the next few years as economic “headwinds” abate. This justifies a large part of the rate increase shown in the dots chart, a view also explicitly stated by Ms Yellen in her speech on policy normalisation.

Regarding the “telltale” signs from inflation and unemployment to guide the “appropriateness” (relative to the “phantom rate”) of the FF rate, what was happening in 2007-08? And what is happening now?

Phantom Rate_0

In 2007-08, Bernanke and the FOMC only had ears for the “siren” of headline inflation, all due to the oil price shock, and couldn´t hear the “muted sound” of core inflation. Plus, unemployment was almost imperceptibly rising, at least initially.

Although unemployment was slowly rising, so was headline inflation. That doesn´t help gauge the “phantom rate” because if the FF rate is above the “phantom rate”, unemployment should be rising but inflation should be falling.

Since headline inflation was rising but unemployment was more or less stuck initially, probably the Fed thought that the “phantom rate” was above the FF rate, which made the Fed reduce the FF rate (after the Bank Paribas affair in August 2007) very parsimoniously. In fact, from April to September 2008 the FF rate remained at 2% (with a bias to increase!)

For the past three years inflation has been falling and is below target, but unemployment insists in falling, “messing up” the signals that inform the Fed about the “phantom rate”, resulting in a “stand-off”  that brings forth a lot of “noise” from policymakers.

If the Fed were to stop trying to figure the “phantom rate” and instead observe the very visible behavior of nominal aggregate spending (or NGDP), it could have tried to save the “plane from dropping too low” in 2008.

Phantom Rate_1

Now that the “plane has dropped too low”, the previous height may not be attainable. But all signals are that there exists an attainable intermediate height that the “captain” could aim for. But that height NGDP level is for the “tower” Fed to specify. Given that the plane´s engines economy has taken a beating, the previous “cruise speed” may have to be lowered. No matter, both labor and capital will “rejoice”.

Phantom Rate_2

Update: The “Phantom” seekers like:

Phantom Rate_3

The NGDP Targeting crowd prefers:

Phantom Rate_4


5 thoughts on “Ruled by a “phantom rate”

  1. As we can see, grappling for a phantom rate is highly error-prone. It’s mystifying that they actually argue their way is better than NGDPLT which would eliminate this sort of deranged monetary policy by tea leaves.

    • Totally agree, inflation target makes you try to guess stuff you don’t really know how to measure well…

  2. one thing I still don’t understand: every Treasury Department auction is over-subscribed. Why do we believe interest rates are not too high?

    • Mr. Cole, 2x or 3x over subscribed is “normal”, meaning nothing wrong abou it. 4x oversubscribed is really a demand level above “normal” (simple rule of thumb from somebody that has done primary offers)

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