51. Looking for the stars: Estimating the natural rate of interest
Mengheng Li, Economics Discipline Group, UTS Business School, University of Technology Sydney; Irma Hindrayanto, Economic Research and Policy Division, De Nederlandsche Bank, The Netherlands
Date of publication: October 2018
Working paper number: 51
Abstract: Natural rate of interest or r-star and the natural rate of output growth are important policy benchmarks widely used by central banks to determine the stance of an economy. It is well recognized that r-star, linearly related to the natural rate of output growth within the New Keynesian framework, is subject to low-frequency fluctuations. To track its evolution over time, we propose an unobserved components model with similar cycles based on the work of Holston et al. (2017). Our model takes an estimate of the time-varying natural rate of output growth as input via a first-stage model based on a first-difference version of Okun’s law with time-varying parameters. In the second-stage, the full model is estimated using Kalman filter. We also show that the similar cycles imply a Taylor rule and a hybrid New Keynesian Phillips curve. For US, EA and UK, our estimates suggest that the decline of natural rate of output growth started from the 1960s, while r-star for US and EA started to fall from 1985. R-star of UK started low during 1960s, but rose and stayed relatively high in the 80s until a big drop took place during the GFC.