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[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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