The natural rate of interest through a hall of mirrors

Phurichai Rungcharoenkitkul and Fabian Winkler

No 974, BIS Working Papers from Bank for International Settlements

Abstract: Prevailing justifications of low-for-long interest rates appeal to a secular decline in the natural interest rate, or r-star, due to factors outside monetary policy's control. We propose informational feedback via learning as an alternative explanation for persistently low rates, where monetary policy plays a crucial role. We extend the canonical New Keynesian model to an incomplete information setting where the central bank and the private sector must learn about r-star and infer each other's information from observed macroeconomic outcomes. An informational feedback loop emerges when each side underestimates the effect of its own action on the other's inference, leading to large and persistent changes in perceived r-star disconnected from fundamentals. Monetary policy, through its influence on the private sector's beliefs, endogenously determines r-star as a result. We simulate a calibrated model and show that this 'hall of mirrors' effect can explain much of the decline in real interest rates since 2008.

Keywords: natural rate of interest; learning; misperception; overreaction; dispersed information; long-term rates; demand shocks; monetary policy shocks (search for similar items in EconPapers)
JEL-codes: D82 D83 E43 E52 E58 (search for similar items in EconPapers)
Pages: 49 pages
Date: 2021-11
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (7)

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Working Paper: The Natural Rate of Interest Through a Hall of Mirrors (2022)
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