Today’s Must-Must Read: Gavyn Davies: Who Is Right About the Equilibrium Interest Rate?

…This justifies a large part of the rate increase shown in the dots chart, a view also explicitly stated by Ms Yellen in her speech on policy normalisation. Mr Summers agrees that the Fed will be forced to deliver the equilibrium rate most of the time, but argues that it cannot do so at the moment because of the zero lower bound…. Summers implies that the equilibrium real rate is not only extremely low… [but] may stay there for many years, thus failing to validate the rise in the equilibrium rate implied by the Bernanke/Yellen view. One interpretation of the market’s pricing of forward short rates is therefore that investors lean on the side of Mr Summers…. The resulting abnormally low real bond yields are obviously a critical under-pinning for buoyant asset prices…. If the FOMC were to make it crystal clear that investors are just downright wrong about the forward path for interest rates, the resulting correction in both bond and equity markets could be severe….

The FOMC… are certainly willing to publish the dots, and to spell out their views on the most likely path for the equilibrium real rate. But they are far from ready to risk a major disruption in the markets by telling investors explicitly that they have misjudged the hawkishness of the Fed. Why is this? Presumably it is because the Yellen camp concedes that there is great uncertainty about the equilibrium real rate…. The Bernanke/Yellen belief that the equilibrium rate will rise in the next 3 years as headwinds diminish is at best conjectural….

What would cause Ms Yellen to act more decisively by ‘shocking’ the market’s path for forward short rates? The equilibrium rate is not directly observable, and is very hard even to estimate within a narrow range. This invites caution. The only reliable signal that the equilibrium rate is rising would be upward pressure on inflation. The so-called ‘whites of their eyes’ policy stance, supported by Mr Summers and several members of the FOMC, would therefore wait until there is clear evidence of rising inflation before becoming confident that the equilibrium rate is rising. Fortunately for global asset prices, Ms Yellen is not yet willing to oppose that point of view with any real conviction.