Navigating by r*: safe or hazardous?

Summary

Focus

The concept of the natural rate of interest, or r-star (r*), has risen to prominence in monetary policy following the Great Financial Crisis. R-star is the real (inflation-adjusted) interest rate that equilibrates output at potential, so that inflation is stable. How useful is this concept as a guide to policy?

Contribution

The lecture offers an in-depth critical evaluation of the concept, from theoretical, empirical and practical perspectives. Based on that, it draws policy conclusions.

Findings

First, since r-star can be estimated only very imprecisely, it can largely be dispensed with when adjusting the policy stance. That said, the notion can still help shape the monetary policy framework and strategy more generally. Second, because of its defining features and depending on how it is employed, r-star has the potential to lead policy astray. In particular, the view that r-star is independent of monetary policy and not much affected by purely financial factors could contribute to a progressive loss of policy room for manoeuvre and complicate the task of regaining it. Finally, should these propositions be valid, there would be a case for greater flexibility within credible policy regimes, – ie tolerance for transitory, but possibly persistent, deviations of inflation from narrowly defined targets. This flexibility could help in adopting a more countercyclical monetary policy strategy and hence also in regaining policy headroom, possibly through a kind of "opportunistic tightening" strategy.  

Abstract

The concept of the natural rate of interest, or r*, has risen to prominence in monetary policy following the Great Financial Crisis. No doubt a key reason for the concept's newfound prominence has been the further decline of real and nominal interest rates to new lows, which has further constrained monetary policy's room for manoeuvre. This lecture explores the extent to which the concept can be a useful guide to policy. It concludes that, depending on how it is employed, the concept has the potential of leading policy astray and of complicating the task of regaining the needed policy headroom. If so, within a credible policy regime, there is a premium on flexibility in the pursuit of tightly defined inflation targets – on tolerance for transitory, but possibly persistent, shortfalls of inflation from target.

Keywords: Natural interest rate, central banking, monetary policy.

JEL classification: E40, E43, E52, E58.