Abstract
Abstract We conduct a Monte Carlo experiment using an ad-hoc New Keynesian model and a tractable agent-based model to generate artificial credit cycle episodes. We show that fluctuations in the implicit measures of the natural rate of interest obtained using a conventional trivariate Kalman filter on these artificial datasets occur in the vicinity of credit cycle peaks without any underlying changes in fundamentals (that is the agents’ type or their behaviour). The empirical analysis confirms that the measures of the natural interest rate tend to increase prior to a credit cycle peak and decrease afterwards. We conclude that a decline in the estimated natural rates of interest does not necessarily indicate changes in macroeconomic fundamentals. Instead, it may simply reflect the innate properties of the measurement technique in the vicinity of credit cycle peaks.
Highlights
Global real interest rates have remained exceptionally low since the Great Financial Crisis, triggering a debate about the causes and consequences of the decline
Estimation of implicit measures of the natural rate of interest is a conventional tool for macroeconomic analysis
The usual presumption is that they reflect structural changes in underlying consumption and investment determinants
Summary
Global real interest rates have remained exceptionally low since the Great Financial Crisis, triggering a debate about the causes and consequences of the decline. There is ample evidence on instability of the relationship between the main macroeconomic variables depending on the state of financial conditions (Silvestrini and Zaghini, 2015, Metiu, Hilberg and Grill, 2015, Gross, Henry J, Semmler, 2017, Carriero, Galvao and Marcellino, 2018, Asanović, 2020, Peña, 2020, Nain and Kamaiah, 2020) Such instability cannot be captured by a simple linear relationship between output, inflation and observed interest rate and will be accommodated by the fluctuations in the natural interest rate estimate. In a related strand of research, Juselius, Borio, Disyatat and Drehmann (2017), Krustev (2018), and Belke and Klose (2019) claim that conventional models for natural interest rate estimation may be misspecified and augment them with financial variables We contribute to this type of analysis by examining the properties of conventional natural interest over different phases of the credit cycle.
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