The wonky interest rate that Janet Yellen was really referring to

U.S. Treasury Secretary Janet Yellen spoke about the prospects for higher interest rates over the weekend, triggering some confusion over which interest rates she was referring to.

“If we ended up with a slightly higher interest rate environment it would actually be a plus for society’s point of view and the Fed’s point of view,” the former Federal Reserve chair told Bloomberg in an interview on Sunday.

Yellen’s remarks come as the Jerome Powell-led Fed continues to pin short-term interest rates at near-zero, with no indication that the central bank will hike rates any time soon.

But Yellen’s remarks on a “slightly higher interest rate environment” are likely referring to interest rates over the longer-term horizon, not the short-term rates set by the Fed eight times each year.

The idea: that over the long-run, the economy can get to a place where it can sustain strong growth and stable inflation at higher interest rates.

But Evercore ISI’s economics team wrote Monday that its clients were “unsettled” by her remarks, which may have been interpreted as jawboning Fed policy. Markets were rattled by similar remarks made by the Treasury secretary a month ago.

“It is hard for a former Fed chair to never touch on rates and the interaction of fiscal and monetary policy when discussing the economy given that this is central to the outlook, though we do think this needs to be handled with care as it is open to misinterpretation,” Evercore ISI’s Krishna Guha wrote.

The fault in r-star

Yellen’s remarks in her Bloomberg interview attempt to get at a macroeconomic concept known as r*, which is an estimate of the “neutral” interest rate that is neither stimulative nor restrictive for the economy.

That estimate has fallen over the last few decades, which is no surprise to savers who have watched rates on their certificates of deposit fall below 1%.

The Federal Reserve drives short-term interest rate policies. The Fed, in addition to other central banks around the world, have recently run into a major conundrum: stimulating economies with low interest rates. Source: Federal Reserve (Federal Reserve)

The COVID-19 crisis raises concerns about the ability of the Fed to eventually “normalize” interest rates. Following the 2008 financial crisis, the Fed was only able to lift short-term rates to almost 2.5% before the China trade war — and then the pandemic — throttled the central bank back to near-zero.

The Fed does not appear optimistic that it will be able to lift rates higher than that over the longer-run.

As of March, the Fed’s estimate of the longer-run interest rate that the economy can sustain is 2.5%.

The Fed's March 2021 Summary of Economic Projections map out each policymakers's expectations for where interest rates may go in the coming years. The "longer run" dots represent their estimates for r*. Source: Federal Reserve (Federal Reserve)

But some economists say there is a chance the Fed may be underestimating the ability of the economy to support a higher interest rate level. At Goldman Sachs, Jan Hatzius and his economics team wrote on May 31 that there may be structural changes to the economy that could boost r*, such as demographics trends and improved productivity coming out of COVID.

New York Fed President John Williams is one of the leading academic minds behind the concept of r*, and told Yahoo Finance on June 3 that an economy able to sustain higher interest rates would be “very positive” for the country.

[Read the full transcript of Yahoo Finance Live's interview with New York Fed President John Williams.]

But he cautioned that estimating r* is just that: an estimate. And like many other macroeconomic variables, it is even harder to forecast in a pandemic.

“I think it's time to be appropriately humble about our ability to draw inference about how does this affect the neutral rate for the next 10 years,” Williams said. “Because I think we're still in the middle of the COVID episode, in terms of seeing how the economy behaves.”

Brian Cheung is a reporter covering the Fed, economics, and banking for Yahoo Finance. You can follow him on Twitter @bcheungz.

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