Measuring the Natural Rate of Interest

Methodology and Approach

• The paper estimates the natural rate of interest (r*), potential output, and trend growth rate jointly using the Kalman filter.

• R* is defined as the real interest rate consistent with output equaling potential and stable inflation.

• The model links the natural rate to the trend growth rate and other unobserved factors.

Key Findings

• The natural rate of interest shows significant variation over the past 40 years in the United States.

• The natural rate is estimated to vary approximately one-for-one with changes in the trend growth rate.

• Estimates show the natural rate peaked around 4.5% in the mid-1960s and reached a low of about 1.25% in the early 1990s.

• Results are generally robust to different model specifications.

Implications for Monetary Policy

• Mismeasurement of the natural rate can lead to significant deterioration in macroeconomic stabilization.

• Using real-time estimates of the natural rate improves policy outcomes compared to assuming a constant rate.

• Time variation in the natural rate is particularly important for understanding monetary policy stance in periods like the late 1960s and early 1990s.

Methodological Details

• The paper uses median-unbiased estimators to address potential biases in estimating variances of unobserved components.

• Several robustness checks are performed, including incorporating labor market data.

Limitations and Uncertainty

• Estimates of unobserved variables like the natural rate have relatively large standard errors.

• The paper acknowledges significant uncertainty around point estimates.

An easy-to-overlook point is that, while the paper presents point estimates, there is considerable uncertainty around these estimates, as highlighted by the reported standard errors and confidence intervals.