Inflation, Presidents, Fed Chairs, and Regime Shifts in the U.S. Real Interest Rate

Abstract

Several recent papers agree on the existence of significant regime shifts in the U.S. real interest rate, but disagree on the proximate causes of the shifts. Caporale and Grier (2000) point to large political changes as correlates, while Rapach and Wohar (2004) show that real rate breaks are correlated with inflation regime shifts and argue that the inflation regime changes cause the real rate shifts. In this paper we show that, controlling for the timing of changes in the inflation regime, dummy variables representing either party change in the Presidency or change in the identity of the Fed Chair are still strongly significant for explaining real interest rate fluctuations. When we control for a fixed coefficient linear relationship between inflation and the real rate, we find two real rate regime shifts that line up almost exactly with the accessions of Paul Volcker and Alan Greenspan. Even if we first let inflation regime switches explain the real rate and then look for regime shifts in the residuals, we find almost exactly the same two breaks. These results imply that Fed Chairs sometimes differ with respect to their preferred equilibrium real interest rate.