The Fault is Not in R Star: Modelling the Neutral Rate of Interest

Abstract

The neutral rate of interest, or R star, is the monetary policy rate at which economic growth will neither accelerate nor slow. As a theoretical concept, and not a directly observable or measurable number, we are only able to estimate it with models rather than measure it directly. We review econometric models (the Holston-Laubach-Williams Kalman filter, and the Del Negro et al. vector autoregression) in Chapter 2, macroeconomic theory models (the New York Fed DSGE, and Carvalho et al's aging demographics model) in Chapter 3, and a financial model (Rungcharoenkitkul and Winkler's ``hall of mirrors'') in Chapter 4. In Chapter 3 we also modify the demographics model to simulate a transient high-immigration period, which resulted in a positive but mostly negligible movement in R star. We also propose a Markov chain model in Chapter 4 to demonstrate that the zero lower bound alone can introduce a wedge between R star and the long-run average of short rates, which is often suggested as a way of measuring long run R star (at least as well as such an average can be captured by long Treasury rates). Finally, in Chapter 5 we analyze the link between fiscal policy and R star by plotting the quarterly changes in the US debt to GDP ratio against the quarterly change in the HLW model's estimate of R star. In this analysis, we found a weak or even negative relationship, which does not support the common assumption in economics that higher government deficits raise R star. Our ultimate conclusion, given the results of other models as well as our own work, is that R star is likely to remain low for the foreseeable future.