Real Interest Rates And Crowding Out: Reagan Era vs. Now

chartFigure 1: 10 year constant maturity Treasurys minus 10 year expected inflation (Blue Chip; Philadelphia Fed Survey of Professional Forecasters) (blue line), and 10 year constant maturity TIPS (red). Nominal yields are average of three months in quarter; expected inflation generally pertains to mid-quarter month. NBER defined recession dates shaded grey. Source: St. Louis Fed FREDII, Philadelphia Fed, NBER and author’s calculations.

Recent commentary on whether real interest rates rose during the Reagan era tax cuts — Kling responding to Krugman — impelled me to look at the data…It appears to me that real interest rates were undeniably higher during the Reagan administration than during, say, the past four quarters of the Obama administration. The difference is 4.56 percentage points, and is statistically significant with p-value of 0.000, using Newey-West standard errors. (I know some people have argued that we should take into account Fed measures; I agree. But those only account for a relatively small proportion of interest rate levels [0].)

Nostalgia time: I remember taking an intermediate macro course at the time of Reagan’s election; the professor (James Duesenberry) predicted crowding out, particularly in business fixed investment (as I recall — my memory of this might be faulty after 30 years). As it turned out, crowding out occurred much more profoundly via net exports, as the dollar surged. When one looks at this alternative mode of “crowding out”, the crowding out argument looks even more, well, lacking of data-based evidence.

chartFigure 2: Log real value of US dollar, broad index. NBER defined recession dates shaded grey. Source: Federal Reserve Board, quarterly averages of monthly data.

The difference is 17.4 per cent (in log terms), and statistically significant at the 1% level.

Previous posts on crowding out: [1] [2]

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