Volker Wieland warns against focusing on equilibrium real interest rate in monetary policy

Central bankers as Fed Chair Janet Yellen and ECB President Mario Drahgi have justified expansionary monetary policy with reference to a decrease in the equilibrium real interest rate. In an essay in the Festschrift „Monetary Economic Issues Today“, Volker Wieland warns against this argumentation. “Under no circumstances should the equilibrium real interest rate serve as crucial justification for the persisting low-interest environment in den United States and the ongoing easing of monetary policy in the euro area”, Wieland concludes. He points out that the estimates are associated with a very high value of uncertainty.

The equilibrium real interest rate corresponds to the real interest rate when GDP corresponds the potential growth and the price level remains constant. If a central bank follows a positive inflation target, this would correspond with the interest rate where inflation coincides with target rate in the long term. As a sum of the equilibrium real interest rate and the inflation target, the nominal interest rate reaches its steady state level and is an important reference mark in monetary policy, taken into account in the Taylor Rule, the most important interest-rate rule in monetary policy.

Refering to an earlier paper with Robert C.M. Beyer, Wieland demonstrates that estimates of equilibrium real interest rates entail a high degree of uncertainty. Furthermore, those are mostly medium-term instead of long-term estimates. Therefore, Wieland argues that equilibrium real interest rates should not have a key role to play in monetary and fiscal policy decisions.

However, if used nevertheless, a consistent application together with associated output estimates call for a tightening of the policy stance in the United States and the euro area, he concludes.

Volker Wieland
"Negativzinsen: Geldpolitik oder Gleichgewichtszins?"
(Negative Interest Rates: Monetary Policy or Equilibrium Real Interest Rate?)

In: Monetary Economic Issues Today. Festschrift in honour of Ernst Baltensperger
Swiss National Bank, Orell Füssli, 2017, pp.289-302