Academic journal article Economic Inquiry

Measuring the World Natural Rate of Interest

Academic journal article Economic Inquiry

Measuring the World Natural Rate of Interest

Article excerpt

I. INTRODUCTION

The natural rate of interest--also sometimes referred as a neutral or real equilibrium rate of interest--is commonly defined as the real short-term rate of interest consistent with stable inflation and output equal to potential. It is one of the key concepts for interpreting macroeconomic relationships and the effects of monetary policy. For example, it provides a metric for the stance of the monetary policy, which is expansionary (contractionary) when the real interest rate is below (above) the natural rate. Thus, monetary policy makers have a deep interest in estimating the level of the natural interest rate. (1)

Most of the previous work on this topic estimates the natural rate for only a single country or a specific area of the world such as the European Union. However, in light of the increasing degree of global economic integration, measuring the global natural rate is of some interest. This article tries to make a contribution in this direction. We assume that the world is fully integrated and ask the following questions: How has the world natural rate evolved over the past half century? Does it exhibit a similar pattern to the natural rate in the United States? What are the main contributors to historical fluctuations in the world natural rate? Does it tell us anything about the international interaction between the United States and the rest of the world?

In order to answer the questions above, we broadly apply a commonly used methodology first proposed by Laubach and Williams (2003) to the world, proxied by an aggregate of 20 advanced economies over the period 1961-2015. (2) Laubach and Williams use a state-space model to estimate the unobservable natural rate from observed output, inflation, and interest rate data by specifying a couple of simple macroeconomic relationships including a crucial natural rate equation relating the natural rate of interest to the trend rate of potential output growth, an investment/saving (IS) curve relating the output gap to the deviation of real interest rate from its natural level, and a Phillips curve that links the inflation rate to the deviation of output from potential.

Our specification and estimation deviate from the original Laubach and Williams model in a couple of ways. First, we omit import prices from our Phillips curve specification since we are interested in global aggregates and the world does not trade with anyone. For the same reason, the FRB/U.S. imported oil price in Laubach-Williams' Phillips curve is replaced with the world oil price proxied by the price of West Texas Intermediate crude oil. Second, we apply standard maximum likelihood methods to estimate the trend growth shock instead of the medium unbiased estimator proposed by Stock and Watson (1998). We do so because shocks to world trend growth are bigger than the respective individual country shocks, so that standard maximum likelihood methods do not suffer from the "pile-up problem" (Stock 1994) as by Laubach and Williams (2003). Third, while implementing the Kaiman filter/smoother algorithm, we set the conditional expectation and covariance matrix of the initial states with a diffuse prior instead of the generalized least squares (GLS hereafter) method proposed by Harvey (1989) because the latter tends to exacerbate the "pile-up problem."

There are several main findings to highlight. First, the world neutral interest rate has been declining for the past half century in a similar pattern as the trend growth rate of potential output. The trend potential output growth can explain over a quarter of the forecast error variance of the natural rate at all finite horizons. Nevertheless, consistent with Hamilton et al. (2016), we find that the relationship between the world natural rate and trend potential output growth is modest. The point estimate of the parameter that connects the natural interest rate with the trend growth rate is 0.458, which is less than half of Laubach and Williams' estimate of its U. …

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