Econometric issues with Laubach and Williams' estimates of the natural rate of interest

Daniel Buncic

Papers from arXiv.org

Abstract: Holston, Laubach and Williams' (2017) estimates of the natural rate of interest are driven by the downward trending behaviour of 'other factor' $z_{t}$. I show that their implementation of Stock and Watson's (1998) Median Unbiased Estimation (MUE) to determine the size of the $\lambda _{z}$ parameter which drives this downward trend in $z_{t}$ is unsound. It cannot recover the ratio of interest $\lambda _{z}=a_{r}\sigma _{z}/\sigma _{\tilde{y}}$ from MUE required for the estimation of the full structural model. This failure is due to an 'unnecessary' misspecification in Holston et al.'s (2017) formulation of the Stage 2 model. More importantly, their implementation of MUE on this misspecified Stage 2 model spuriously amplifies the point estimate of $\lambda _{z}$. Using a simulation experiment, I show that their procedure generates excessively large estimates of $\lambda _{z}$ when applied to data generated from a model where the true $\lambda _{z}$ is equal to zero. Correcting the misspecification in their Stage 2 model and the implementation of MUE leads to a substantially smaller $\lambda _{z}$ estimate, and with this, a more subdued downward trending influence of 'other factor' $z_{t}$ on the natural rate. Moreover, the $\lambda _{z}$ point estimate is statistically highly insignificant, suggesting that there is no role for 'other factor' $z_{t}$ in this model. I also discuss various other estimation issues that arise in Holston et al.'s (2017) model of the natural rate that make it unsuitable for policy analysis.

Date: 2020-02, Revised 2020-08
New Economics Papers: this item is included in nep-ecm and nep-ets
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Citations: View citations in EconPapers (4)

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Working Paper: Econometric issues with Laubach and Williams’ estimates of the natural rate of interest (2020)
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