A New Approach to Estimating the Natural Rate of Interest

Benati, Luca (August 2016). A New Approach to Estimating the Natural Rate of Interest (Discussion Papers 16-10). Bern: Department of Economics

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I illustrate a novel, and straighforward method to extract the natural rate of interest from the joint dynamics of inflation and the term structure of nominal interest rates, based on cointegrated structural VARs. The key identifying assumption is that the unit root component of nominal interest rates is driven by two permanent shocks, an inflation shock, and a shock to the natural rate, which can be disentangled via standard SVAR techniques.
I estimate the natural rate for the Zero Lower Bound (ZLB) period by simulating the pre-ZLB estimated system conditional on the actual dynamics of the unconstrained variables at the ZLB, and then imposing the identifying restrictions upon the conditional projections. Evidence suggests that since the beginning of the financial crisis the natural rate has decreased, in the United States, by 0.5-0.7 percentage points, and it stands, in the second half of 2016, at about 0.5 per cent.

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