Ethan S. Harris’s research while affiliated with Bank of America Merrill Lynch and other places

We examine the behavior, determinants, and implications of the equilibrium level of the real federal funds rate, interpreted as the long run or steady state value of the real funds rate. We draw three main conclusions. First, the uncertainty around the equilibrium rate is large, and its relationship with trend GDP growth much more tenuous than widely believed. Our narrative and econometric analysis using cross-country data and going back to the 19th century supports a wide range of plausible estimates for the current level of the equilibrium rate, from a little over 0 per cent to the pre-crisis consensus of 2 per cent. Second, a bivariate vector error correction model that looks only to U.S. and world real rates well captures the behavior of U.S. real rates. The model treats real rates as cointegrated unit root processes. As of the end of our sample (2014), the model forecasts the real rate in the U.S. will asymptote to an equilibrium value of a little less than half a percent by 2021. Consistent with our first point, however, confidence intervals around this point estimate are huge. Third, the uncertainty around the equilibrium rate argues for more “inertial” monetary policy than implied by standard versions of the Taylor rule. Our simulations using the Fed staff’s FRB/US model show that explicit recognition of this uncertainty results in a later but steeper normalization path for the funds rate compared with the median “dot” in the FOMC’s Summary of Economic Projections.

While the economy shows signs of strength, the recovery remains tepid relative to economic upswings following deep recessions of the past. This weakness has occurred despite an aggressive monetary response by the Federal Reserve which has adopted even unconventional tools to reduce long term interest rates. A variety of factors have been blamed for the tepid recovery, including the financial crisis of 2008, uncertainty over policy, and high levels of indebtedness.In this report, we focus on weakness in housing. Our analysis makes two broad points. First, weakness in housing and residential investment is a main impediment to a robust recovery. Second, problems related to housing have affected the transmission of monetary policy. More specifically, the unprecedented decline in house prices and residential investment has introduced headwinds that may require a more aggressive monetary response than in normal downturns. Further, problems related to housing markets may reduce the sensitivity of real economic activity to the interest rates that monetary policy can affect. Or in the parlance of textbook intermediate macroeconomics, housing problems have likely shifted the IS curve leftwards and steepened the slope of the curve by introducing a gap between policy rates and effective rates. For both of these reasons, problems related to housing introduce significant challenges to monetary policy-making.