The real rate of interest from 1800–1990

Abstract

Spurred by the work of Mehra and Prescott (M-P), economists have been attempting to explain the surprisingly low levels of real interest rates in light of the behavior of aggregate consumption. This paper constructs a continuous 'risk-free' interest rate series for the United States and the United Kingdom from the beginning of the nineteenth century, extending the period analyzed by M-P, 1889–1978, both backward and forward. It is found that the real rate of return on both long- and short-term bonds was over 400 basis points lower during the M-P period than outside that period and that this result holds for the U.K. as well as the U.S. In contrast, equities show almost identical real returns over the whole sample so that the equity premium is only about one-third as large outside the M-P period as within the period. These new data help reconcile the behavior of consumption and the real rate and suggest that the data from 1889–1978 may not be characteristic of returns on fixed income investments in the future.