Yellen Suggests Equilibrium Real Rate for Overnight Money is Zero

The most interesting tidbit to me in Janet Yellen’s post-FOMC press conference yesterday was when she was discussing the neutral real rate of interest (net of inflation) for an American economy running at trend growth near full employment.  She cited that there is some research that suggests that that rate is now zero percent.  Now think about that for a moment.  What she is saying is that there is no time value to money on short time scales.  Just a few short years ago the Fed itself had Fed Funds at 5 and 6% when stated inflation was running in the 2-3% range so representing an equilibrium real rate of around 2%.

She then actually went on to describe the reasons why it is so and that these reasons are durable.  Those are the two biggies which are rarely mentioned by the academicians though they are the two most important items on the intellectual scene; the demographic nightmare staring the developed world in the face and the poor showing for productivity in recent quarters and years.  I recently attended a talk by Jim Paulsen of Wells Fargo in which he theorized that productivity is not as low as reported.  Recall that productivity is a derivative quantity that falls out once you account for output and its labor inputs.  His theory was that output was higher than stated so productivity would then also be higher than reported.

But there is a second possibility, which has been talked about by Jeff Snider of Alhambra Capital in his writings at Seeking Alpha, and this is that labor has been overstated thus leading to an understatement of productivity.  I would buy that argument if for no other reason than the composition of labor has tilted toward part time work, partly at least due to Obamacare.  But then again, withholding taxes reported by the US Treasury have supposedly been very high and rising until the start of 2016 so there is some good evidence for a strong labor market prior to 2016, notwithstanding the tremendous drop in the number of those in the labor force.  I have yet to see anybody come forward with an argument how such taxes can be high but the labor market strength overstated.  It remains a conundrum as does so much else about the economy in the aftermath of the GFC.

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