Monetary policy and the drifting natural rate of interest

Empirical analyses starting from Laubach and Williams (2003) find that the natural rate of interest is not constant in the long-run. This paper studies the optimal response to stochastic changes of the long-run natural rate in a suitably modified version of the new Keynesian model. We show that, bec...

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Bibliographic Details
Published inIDEAS Working Paper Series from RePEc
Main Authors Daudignon, Sandra, Tristani, Oreste
Format Paper
LanguageEnglish
Published St. Louis Federal Reserve Bank of St. Louis 01.01.2022
Subjects
Interest rates
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Summary:Empirical analyses starting from Laubach and Williams (2003) find that the natural rate of interest is not constant in the long-run. This paper studies the optimal response to stochastic changes of the long-run natural rate in a suitably modified version of the new Keynesian model. We show that, because of the zero lower bound (ZLB) on nominal interest rates, movements towards zero of the long-run natural rate cause an increasingly large downward bias in expectations. To offset this bias, the central bank should aim to keep the real interest rate systematically below the long-run natural rate, as long as policy is not constrained by the ZLB. The neutral rate – the level of the policy rate consistent with stable inflation and the natural rate at its long-run level – will be lower than the long-run natural rate. This is the case both under optimal policy, and under a price level targeting rule. In the latter case, the neutral rate is equal to zero as soon as the long-run natural rate falls below 1%.