Productivity and the Term Structure

In discussions about the recent record-setting economic expansion and the accompanying record-setting bull market in stocks, two factors often receive credit: Federal Reserve interest rate policy and increased productivity. This conjunction naturally raises the question of what interest rate policy is appropriate in the face of changing productivity. Before such a policy question can be answered, however, the logically prior question of the effects of productivity changes on interest rates must be addressed. The Federal Reserve controls one particular short-term rate: the federal funds rate. Investors, consumers, and businesses generally care about long-term rates: mortgages, car loans, corporate bonds. This Economic Review considers how productivity changes affect the entire term structure of interest rates. It thus may serve as a prelude to thinking about how the Federal Reserve (FOMC) should move the Federal Funds rate in response to productivity changes or movement in other interest rates. To get a handle on the economics behind productivity’s effect on the term structure, this paper works out a simplified theoretical model based on the work of Cox, Ingersoll, and Ross (1985a,b) and Sun (1992). This approach abstracts from reality: it posits a very simple production structure and it ignores money and inflation.1 This means that it ignores several vital influences on the term structure, principally how productivity affects the part of interest rates that depends on inflation and expectations about inflation. One big advantage of writing down a theoretical model in all its detail is that we are forced to answer a host of questions that might not naturally come up. When we talk about a productivity change (or shock) is that change permanent or temporary? Do we expect it to be repeated—or offset—in the near future? To get answers we must be precise about our assumptions. I. The Basic Economy