Three Scenarios for Interest Rates in the Transition to Normalcy

Abstract

In this article, time-series models are developed to represent three alternative, potential monetary policy regimes as monetary policy returns to normal. The first regime is a return to the high and volatile inflation rate of the 1970s. The second regime, the one expected by most Federal Reserve officials and business economists, is a return to the credible low inflation policy that characterized the U.S. economy from 1983 to 2007, a period known as the Great Moderation. The third regime is one in which policymakers keep policy interest rates at or near zero for the foreseeable future; Japanese data are used to estimate this regime. These time-series models include four variables: per capita gross domestic product growth, consumer price index inflation, the policy rate, and the 10-year government bond rate. These models are used to forecast the U.S. economy from 2008 through 2013 and represent the possible outcomes for interest rates that may follow the return of monetary policy to normal. Here, “normal” depends on the policy regime that follows the liftoff of the federal funds rate target expected in mid-2015.

JEL Classification: E43, E47, E52, E58, E65