How CBO Projects the Real Rate of Interest on 10-Year ...
[Pages:34]Congressional Budget Office Background Paper
How CBO Projects the Real Rate of Interest on 10-Year Treasury Notes
December 2007
the congress of the united states
Pub. No. 2886
CBO
How CBO Projects the Real Rate of Interest on 10-Year Treasury Notes
December 2007
The Congress of the United States O Congressional Budget Office
Note
The figures in this background paper use shaded vertical bars to indicate periods of recession as well as dashed vertical lines to separate actual from projected data. (A recession extends from the peak of a business cycle to its trough.)
Preface
Twice a year, the Congressional Budget Office (CBO) makes 10-year projections of
the budget that assume a continuation of current policies and laws. Those projections depend in part on the outlook for the economy. This background paper describes CBO's methodology for projecting the real (inflation-adjusted) rate of interest on 10year Treasury notes--which is important because it not only affects (and is affected by) economic activity but also directly influences federal outlays, as interest payments on federal debt depend on it.
Angelo Mascaro and Steven Weinberg of CBO's Macroeconomic Analysis Division prepared this paper, with assistance from Adam Weber and under the supervision of Robert Dennis, John Peterson, and Kim Kowalewski. Larry Ozanne and Thomas Woodward of CBO's Tax Analysis Division helped with incorporating tax effects into the analysis. Douglas Hamilton, Arlene Holen, Mark Lasky, Donald Marron (formerly of CBO), Marvin Phaup, and Marika Santoro provided comments on a draft.
John Skeen edited the paper, and Christine Bogusz proofread it. Maureen Costantino prepared the paper for publication. Lenny Skutnik produced the printed copies, Linda Schimmel coordinated the distribution, and Simone Thomas prepared the electronic version for CBO's Web site ().
December 2007
Peter R. Orszag Director
Contents
Introduction 1 Estimating and Forecasting the Natural Rate of Interest 3
The Return on Capital 3 Adjustments for Equity and Credit Risk 7 Projecting the Natural Rate of Interest 12 Estimating and Forecasting the Real Rate on 10-Year Treasury Notes 12 Estimates of the Real Rate on 10-Year Treasury Notes over
History 15 Forecasting the Real and the Nominal 10-Year Treasury Rates 18 Appendix A: Calculating the Long-Run Equilibrium Return on Capital 21 Appendix B: Calculating the Risk-Adjusted Return on Capital 23
v
Figures
1. The Natural Rate of Interest and the Real Rate on
10-Year Treasury Notes
2
2. Return on Capital from the Income Side of the
National Income and Product Accounts
4
3. The Income-Side and Product-Side Measures of the
Return on Capital
6
4. The Equity-Risk Premium Derived from the
Difference Between the Real Return on
Equity and the Real Rate on 10-Year
Treasury Notes
10
5. The Credit-Risk Premium Derived from the
Difference Between the Rates on Moody's
Baa Corporate Bonds and 10-Year
Treasury Notes
11
6. The Combined Risk Premium
13
7. The Natural Rate of Interest and the Tax-Adjusted
Return on Capital
14
8. The Rate of Interest on 10-Year Treasury Inflation-
Protected Securities
16
9. The Real Rate on 10-Year Treasury Notes Using 10-Year and One-Year Expectations of Inflation 17
10. Two Measures of the Real Rate on 10-Year
Treasury Notes
20
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