Reflections on the natural rate of interest, its measurement, monetary policy and the zero lower bound

Persistent decreases in interest rates since the beginning of the twenty first century and the intensification of this trend with the onset of the global financial crisis nurtured the view that the natural rate is substantially lower than it used to be, and by some estimates, even persistently negative. Although investment activity depends mainly on risky rates existing estimates of the natural rate focus mainly on estimation of natural (mostly short term) riskless rates. Gilchrist and Zakrajšek (2012) find that, particularly during crisis times, risky and riskless rates tend to move in opposite directions and that the spread between risky and riskless rates is a good predictor of subsequent economic activity. Drawing on those findings the paper makes a case for conceptualizing and estimating a risky natural rate. This rate which better reflects the impact of the financial system on economic activity, is practically always bounded away from the zero lower bound. After documenting and reviewing the downward trend in world interest rates and the reasons underlying it the paper argues that recent post crisis estimates of the riskless natural rate are likely to be biased downward. Recent estimate of the (unobservable) natural rate are obtained by applying either the Kalman filter or Bayesian estimation to alternative standard versions of the New Keynesian (NK) model. The crisis substantially increased the tightening impact of credit rationing on the New Keynesian (NK) IS relation and the relative importance of the financial stability motive in the monetary policy rule. Since the standard NK model abstracts from credit rationing and from the financial stability motive existing estimates of the natural rate are likely to be biased downward, particularly so since the onset of the crisis.