The Natural Rate of Interest Through a Hall of Mirrors

Phurichai Rungcharoenkitkul and Fabian Winkler

No 2022-010, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: Prevailing explanations of persistently low 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 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, possibly 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: 48 p.
Date: 2022-03-18
New Economics Papers: this item is included in 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 (4)

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Working Paper: The natural rate of interest through a hall of mirrors (2021)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgfe:2022-10

DOI: 10.17016/FEDS.2022.010

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