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Are Real Interest Rates Too High?
Money Marketeers of New York University
New York, New York
September 21, 1999


s I travel around talking about monetary policy—sometimes in speeches
and sometimes with professional
friends in a casual setting—a common
question concerns my views about interest rates.
Of course, I always beg off when the question
concerns possible future FOMC actions; however,
when the question concerns how I interpret the
current level of the real, or inflation-adjusted, rate
of interest, I find the topic more congenial. In
many cases, the “question” put to me is more a
claim than a question. Real interest rates are high,
so the argument goes, and the claim follows that
monetary policy is restrictive. This evening gives
me an opportunity to discuss this issue with
some care, and I think it safe to assume that the
issue is of interest to this group.
Before proceeding, I want to emphasize that
the views I express here are mine and do not
necessarily reflect official positions of the Federal
Reserve System. I thank my colleagues at the
Federal Reserve Bank of St. Louis—especially
Mike Pakko—for their assistance and comments,
but I retain full responsibility for errors.
Given the sensitivities and ample opportunities for misinterpretation whenever a Fed official
discusses interest rates, I want to be absolutely
clear that my remarks tonight have nothing to do
with my own position on short-run monetary
policy. My topic tonight concerns the average
level over time of the real, or inflation-adjusted,
rate of interest. I am not talking about the nominal
federal funds rate for which the Fed determines
an intended range at each meeting of the Federal
Open Market Committee.
Viewed historically, nominal interest rates in
the United States are high today compared with

the trend rate of inflation—in other words, the
real rate of interest is high. For example, the
interest rate on 1-year U.S. Treasury securities is
currently roughly 5 percent. If we take the recent
inflation trend of around 2 percent to be a good
indicator of the outlook for future inflation, then
the real rate on 1-year T-bills is about 3 percent.
This real rate compares with an average inflationadjusted return on 1-year T-bills of less than 2
percent over the past 50 years. Similarly, the real
yield on long Treasuries is about 4 percent today,
which is about 1 percentage point higher than
typical for the U.S. economy.
Some point to this observation as evidence
that monetary policy is too tight—that the Fed is
somehow forcing real interest rates up and choking
off economic growth. In my remarks this evening,
I’d like to focus on the proposition that high real
interest rates are not a constraint to growth, but
in fact are a consequence of an economy in the
midst of a robust expansion, with optimistic
prospects for the future. Indeed, if I were to try
to be provocative, I’d say that I wish real interest
rates were even higher today than they are. I’d say
that because of my conviction that an economy
enjoying even faster productivity growth and even
better opportunities for profitable business investment than we see in today’s economy would be
characterized by a higher real rate of interest than
we see in the market today.
Before anyone pulls out a cell phone to report
that, “Poole sees need for higher rates,” let me
say that my choice of this topic tonight reflects
my frustration that reporting about interest rates
concentrates almost exclusively on the supply
side of the credit market, which the Fed influences, and neglects the demand side of the credit


market, which is determined by economic fundamentals. My basic message is that all of us should
crave an even more robust economy, which would
in turn yield an even higher real rate of interest,
than we have seen over the last few years.
I’ll proceed by first outlining a few measurement issues before getting into the meat of my
argument—the state of investment demand and
saving supply in the U.S. economy over recent
years. I’ll then turn to the issue of inflation uncertainty before concluding with a few general comments. I hope that I can provoke you enough to
ask a few questions when I finish.

In some sense, the convention in economics
of referring to an inflation-adjusted interest rate
as a “real interest rate” is misleading. The real rate
of interest is not real in the sense that we can go
out and easily observe it the economy. Certainly,
we can measure the inflation-adjusted return
that an investor receives after a debt contract has
matured, but this ex post measure tells us only
how inflation has eroded the return on an investment over some past period.
When it comes to analyzing current economic
conditions and evaluating the outlook for the
future, a more relevant measure of the real interest
rate is a forward-looking measure. Since the decisions of savers and investors in an economy are
predicated on their expectations about the future,
it is the level of current market interest rates
adjusted for expected future inflation—the ex ante
real rate of interest—that matters.
Measuring expectations, of course, is an
inherently difficult matter. We can conduct surveys, estimate statistical models, draw inferences
from economic theory, but we can never measure
precisely the public’s attitude about the outlook
for inflation. In fact, it is precisely this prospect
of disentangling inflation expectations from
observed market interest rates that makes the
evaluation of real interest rates so challenging.
We are fortunate today to be able to observe
yields on indexed bonds, but even here, a meas2

urement issue clouds the picture. The indexed
Treasury issues trade infrequently, and some part
of their measured yield reflects their relative
illiquidity. In any event, to analyze real rates in
historical perspective, we have to make judgments about measurements before the indexed
Treasury bonds were available in the market.

Drawing on what we do know about its behavior, a high real interest rate is not something that
we should necessarily fear. In the current economic expansion, characterized by a high rate of
investment spending and the potential for rising
productivity growth, a high real interest rate is
exactly what we should expect.
This observation does not mean that a high
real rate is something we should strive for or
embrace as a monetary policy objective. The
inflation expectations built into market interest
rates, however rational, are not always correct. If
at any given time, the inflationary potential of the
monetary policy in place is not fully recognized,
overly expansionary policy might be associated
with excess demand pressures for goods and services that would put upward pressure on interest
rates, both nominal and real.
Interpreting the real interest rate is consequently a difficult prospect. But as we consider
the factors that likely underlie its recent behavior,
both economic theory and recent history suggest
that, while there is good reason to monitor the
real rate’s behavior closely for indications about
the appropriate stance of monetary policy, its
current level gives little cause for alarm.
Indeed, I am convinced that the real rate of
interest in the bond market is high today for all
the right reasons. Funds invested in the bond
market have to compete with funds invested in
productive businesses. We know that business
investment spending is strong; that in recent years,
corporate earnings have grown smartly; that the
stock market valuations reflect confidence in the
future; and that economywide productivity growth
has surged since 1995. These are all signs of a

Are Real Interest Rates Too High?

high return on invested capital. We have a lot to
celebrate in this economy, and the high real rate
in the bond market reflects the fundamentals we

One of the most distinctive features of the
current economic expansion has been the strength
and persistence of investment spending. In 1998,
real fixed investment rose to nearly 17 percent
as a proportion of GDP, surpassing recent cyclical
peaks of around 15 percent and setting a record
high for the post-World War II period. This rate
of investment shows little sign of abating.
The rapid rate of investment is surely one of
the most important factors in explaining high real
interest rates. The financing of investment spending draws on the availability of loanable funds
in the economy. As firms compete for funds to
finance their investment projects, rising interest
rates serve as the key mechanism by which credit
markets efficiently allocate resources to the most
productive ventures.
Evidence suggests that the current investment
boom is related to the adoption of new technologies in information processing and telecommunication. For example, the share of overall fixed
investment spending devoted to information
processing equipment has risen sharply in the
latter half of the 1990s, increasing from 28 percent
in 1995 to more than 40 percent so far this year.
As rapid investment spending contributes to
an upgrading of the nation’s capital stock, the
prospects for rising productivity in the future are
enhanced as new technologies are adapted and
integrated into production processes. A high real
interest rate in the bond market today is a forecast
of productivity gains in the future. I surely hope
that forecast is correct.

On the other side of the ledger, the recent
decline in the U.S. saving rate may be another

contributing factor to the level of real interest rates.
A low saving rate can strain the availability of
loanable funds in the economy. The resulting
scarcity of funds reinforces the upward pressure
put on real interest rates by rapid investment
Indeed, saving rates have fallen precipitously
over the past four or five years. The personal
saving rate declined from about 3.5 percent in
1994 to near zero over the past year. Negative
personal saving rates have even been measured
over the first two quarters of 1999.
Of course, measurement issues crop up in
evaluating the saving rate: Saving is calculated
as a residual from the data on personal income
and spending, and the income measure used for
these calculations does not incorporate unrealized
capital gains. Given the recent run-up of equity
values, the omission of prospective capital gains
represents a potentially important factor in the
measurement of the saving rate. These technical
issues aside, however, it seems clear that the
current rate of saving is low in the United States,
particularly at this stage in a mature economic
Economic theory tells us that as people make
their consumption and saving decisions over the
business cycle, we should expect to see saving
rates rise over the course of an expansion. In the
early stages of an expansion, pent-up demand
usually gives rise to rapid spending and low
saving. Near the cycle peak, however, the pace
of spending subsides, and the saving rate should
rise as people set aside a higher proportion of
their income gains as a hedge against leaner times
in the future.
This pattern is typical of what we usually
observe in the data as well. The saving rate tends
to fall as the economy enters a recession, but then
rises as the economic recovery matures. The dramatic, sustained decline in the saving rate in the
late 1990s is somewhat unusual in this regard and
represents another distinguishing characteristic
of the current expansion.
One explanation for the current pattern is
that people do not foresee the need to set aside
resources for the future. Perhaps people’s expecta3


tions for future growth have been revised upward,
and current economic conditions are seen merely
as a foretaste of the prosperity to come.
Indeed, if the slowdown in productivity
growth that began in the 1970s has truly turned
around—as I and many others have suggested—
then a low saving rate would not be surprising.
Correspondingly, a rising growth trend for the
U.S. economy would suggest a lasting rise in real
interest rates, since it is the underlying growth
rate of productivity that ultimately determines
both the economy’s growth rate and the rate of
real return available to savers and investors.
Although I would like to see a higher saving
rate in the United States, my judgment is that the
low personal saving rate has little or nothing to
do with the level of the U.S. real rate of interest
today. World capital markets are highly integrated,
and the flow of capital into the United States from
abroad is large. Thus, in explaining the level of
U.S. real rate of interest, I put my emphasis on
the robust U.S. economy and the tremendous
investment opportunities it offers.

The foregoing analysis of economic fundamentals provides us with some insight into why
real interest rates are high; moreover, it gives
cause for optimism about future prospects for
the U.S. economy. There are other reasons to be
somewhat less sanguine, however.
One difficulty of disentangling inflation expectations from the real interest rate is the issue of
inflation uncertainty. A risk premium associated
with this uncertainty could cause measured real
rates to be high. That is, when we subtract reasonable estimates of expected inflation from market
interest rates, we are left with a measure that combines the true, underlying real rate and a component that compensates for the risk associated with
uncertainty about future inflation. The measured
high real rate—the nominal bond yield less
expected inflation—might therefore reflect the
lingering legacy of past inflation and fears that
those dark days might return.

Some fascinating recent research by Martin
Evans, of NYU, on the experience of the United
Kingdom during the 1980s highlights the importance of inflation risk in the decomposition of
market rates into real and expected inflation components. Evans examines the behavior of U.K.
interest rates, comparing returns on Britain’s
inflation-adjusted bonds with those of comparable
nominal bonds. His findings confirm those of
previous researchers who suggest that uncertainty
about future inflation gives rise to a risk premium
in market rates on nominal bonds that is significant and that varies over time. Moreover, this risk
premium appears to be related to fears of a dramatic resurgence of inflation that is unlikely to
occur, but would be devastating if it did.
Concerns about such low-probability events
are more likely to be present in economies that
have gone through recent bouts of high inflation.
Anecdotal evidence suggests that such lingering
fears can be slow to dissipate. For example, many
astute observers have suggested that the
Bundesbank’s anti-inflation fervor since World
War II, and the public support for such policies,
may well be related to the experience of German
hyperinflation in the early 1920s!
Along these lines, the recently retired director
of research at the St. Louis Fed, William Dewald,
has often argued that measured real interest rates
constitute an indicator of monetary policy credibility. In particular, he suggests that countries
with relatively high measured real interest rates
are those in which concerns about rising inflation
are more prevalent.
If measured real rates in the United States
are indeed an indicator of this type of inflation
uncertainty, then rates could decline if the Fed
were able to offer more clear assurance that inflation will not resurface in the future. Public opinion
and market sentiment, however, already appear
to grant a great deal of credibility to the Federal
Reserve’s commitment to keeping inflation in
Minimizing the probability of unexpected
fluctuations in the inflation rate will continue to
be an important objective of monetary policy.
Ultimately, the only true way we will be able to

Are Real Interest Rates Too High?

enhance credibility in this regard is through sustained high performance.

inflation. If we can infer that information from
measures of the real interest rate, we would be
foolish to ignore it. But we must also recognize
the potential pitfalls of misinterpretation.

Another potential concern about the level of
real interest rates is the possibility that high rates
are being driven by unsustainable aggregate
demand growth. As strange as this may sound,
estimates of high real interest rates might indicate
an overly stimulative monetary policy stance—
one with future inflation potential that has yet to
be fully recognized.
Market expectations, however rational, are
not always correct. If high market interest rates
reflect overly robust aggregate demand, fueled
by an excessively stimulative monetary policy,
then a high real interest rate—conditioned on the
presumption that inflation will remain in check—
might be an indicator of incipient inflationary
The confidence that markets have shown in
the Fed’s commitment to price stability is heartening, but if that confidence turns out to have been
misplaced, the goal of long-term price stability
will be even more difficult to attain. Consequently,
a key challenge facing monetary policymakers is
to determine whether today’s provision of liquidity to the economy is appropriate for maintaining
maximum sustainable growth (in an environment
where that maximum is uncertain) or whether it
is fueling unsustainable aggregate demand growth
that will ultimately lead to inflation.
In making that judgment, we should take in
account everything we know about expectations
regarding prospects for economic growth and

I hope that I have conveyed to you both the
richness of the information contained in the real
interest rate, as well as some of the problems that
economists and policymakers face in trying to
extract that information. Research on the measurement and interpretation of real rates will undoubtedly continue, giving us greater clarity with which
to evaluate the signals about the economy that
are embedded in interest rates.
As a final comment on the level of the real
interest rate in recent years, I’d like to again view
our current situation in the perspective of recent
history. The real rate may be somewhat high today,
but not so long ago it was near zero. Real rates
were low in the early 1990s, as the economy
emerged only sluggishly from the recession of
1990-91. An even more significant period of low
real rates was in the late 1970s, when inflation was
accelerating and economic growth was stagnant.
Given the choice of living in a world with
low real interest rates, reflecting some combination of high inflation and low economic growth,
or living in a world with high real rates, reflecting rapid growth and an optimistic outlook for
the future, I have no problem in deciding which
world to choose. I doubt that any of you have a
problem making this choice either.