The Risk-Adjusted Real Long-Term Real Rate

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Summary

  • One argument against the secular stagnation thesis is that the risk-adjusted real rate is not particularly low.
  • Real risk-free rates have declined, particularly relative to the 1980s.
  • However, it is true that the decline is less apparent than in the typical graph using unadjusted real rates.

Editor's note: This article was originally published on April 30 by Menzie Chinn here.

One argument against the secular stagnation thesis is that the risk-adjusted real rate is not particularly low. I’m dubious.

In Figure 1, I depict the real ten-year Treasury yield, adjusted by survey-based inflation expectations (from the Cleveland Fed, Survey of Professional Forecasters), and the TIPS yield.

Figure 1: Ten-year constant maturity Treasury yield adjusted Cleveland Fed ten-year expected inflation and Kim-Wright term spread (dark blue), adjusted by Survey of Professional Forecasters median ten-year expected inflation and Kim-Wright term premium (teal +), and TIPS yield adjusted by Kim-Wright term premium (red). NBER-defined recession dates shaded gray. Source: Fed, Cleveland Fed, NBER and author’s calculations.

Notice that real risk-free rates have declined, particularly relative to the 1980s. However, it is true that the decline is less apparent than in the typical graph using unadjusted real rates. This is shown in Figure 2.

Figure 2: Ten-year constant maturity Treasury yield adjusted Cleveland Fed ten-year expected inflation and Kim-Wright term spread (dark blue), quadratic trend (gray), and ten-year constant maturity Treasury yield adjusted Cleveland Fed ten-year expected inflation (pink). NBER defined recession dates shaded gray. Source: Fed, Cleveland Fed, NBER and author’s calculations.

The adjusted real ten-year rate is trend-stationary (can reject a unit root null). I estimate a quadratic trend shown in Figure 2. The trend is downward-sloping, and statistically significantly so. In other words, risk-adjusted rates are lower.

It may be the case that the risk-adjusted real rate rises in the near future. I will merely note that yet another alternative measure of the (short) risk-free natural rate (Laubach-Williams 1-sided estimate) suggests that real rates are low...

Figure 3: Ten-year constant maturity Treasury yield adjusted Cleveland Fed ten-year expected inflation and Kim-Wright term spread (dark blue), and Laubach-Williams one-sided estimates of natural rate (teal). NBER-defined recession dates shaded gray. Source: Fed, Cleveland Fed, Atlanta Fed, NBER and author’s calculations.

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.

This article was written by

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James D. Hamilton has been a professor in the Economics Department at the University of California at San Diego since 1992. He served as department chair from 1999-2002, and has also taught at Harvard University and the University of Virginia. He received a Ph.D. in economics from the University of California at Berkeley in 1983. Professor Hamilton has published articles on a wide range of topics including econometrics, business cycles, monetary policy, and energy markets. His graduate textbook on time series analysis has over 14,000 scholarly citations and has been translated into Chinese, Japanese, and Italian. Academic honors include election as a Fellow of the Econometric Society and Research Associate with the National Bureau of Economic Research. He has been a visiting scholar at the Federal Reserve Board in Washington, DC, as well as the Federal Reserve Banks of Atlanta, Boston, New York, Richmond, and San Francisco. He has also been a consultant for the National Academy of Sciences, Commodity Futures Trading Commission and the European Central Bank and has testified before the United States Congress. _________________________________________________ Menzie D. Chinn is Professor of Public Affairs and Economics at the University of Wisconsin’s Robert M. La Follette School of Public Affairs. His research is focused on international finance and macroeconomics. He is currently a co-editor of the Journal of International Money and Finance, and an associate editor of the Journal of Money, Credit and Banking, and was formerly an associate editor at the Journal of International Economics and the Review of International Economics. In 2000-2001, Professor Chinn served as Senior Staff Economist for International Finance on the President’s Council of Economic Advisers. He is currently a Research Fellow in the International Finance and Macroeconomics Program of the National Bureau of Economic Research, and has been a visiting scholar at the International Monetary Fund, the Congressional Budget Office, the Federal Reserve Board and the European Central Bank. He currently serves on the CBO Panel of Economic Advisers. With Jeffry Frieden, he is coauthor of Lost Decades: The Making of America’s Debt Crisis and the Long Recovery (2011, W.W. Norton). He is also a contributor to Econbrowser, a weblog on macroeconomic issues. Prior to his appointment at the University of Wisconsin–Madison in 2003, Professor Chinn taught at the University of California, Santa Cruz. He received his doctorate in Economics from the University of California, Berkeley, and his AB from Harvard University.
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