International Monetary Fund Brookings Institutions “Measuring the Natural Rate of Interest Redux” by Thomas Laubach and John C. Williams Discussion by Maurice Obstfeld Economic Counsellor International Monetary Fund Brookings Institutions Washington, October 30, 2015

Two key questions about natural real interest rates How low? How long? 2

U.S. short and long real rates U.S. real rates (percent) \\data1\res\Bloomberg\PPT\2016\WEMD\1JAN\Data\Real_Bond_Yield_USonly.xlsx Sep. 15 Sources: Bloomberg, L.P., and Federal Reserve Bank of Philadelphia. Note: Real rates are calculated based on nominal government bond yields minus SPF CPI inflation expectations. 3

Monetary policy: Perils of ZLB. Fiscal policy: Policy space post-GFC? Why does it matter? Monetary policy: Perils of ZLB. Fiscal policy: Policy space post-GFC? Danger of debt deflation: Vicious cycle as higher real debts (private plus public) push prices lower. If they are indeed linked as theory says, low real interest rates could foretell lower future growth. 4

Partial list of recent views about real interest rates IMF, April 2014 WEO: [R]eal interest rates will likely remain low enough for the zero lower bound to reemerge should risks of very low growth in advanced economies materialize. Hamilton et al. (August 2015): [T]he equilibrium rate may have fallen, but not by as much as some suggest. Council of Economic Advisers (July 2015): A number of factors … have contributed … with many of these factors suggesting that long-run equilibrium interest rates have fallen. Pescatori and Turunen, IMF WP/15/135 (June 2015): Neutral rates likely turned negative during the Global Financial Crisis and are expected to increase only gradually looking forward. Bean et al., Geneva Report 17 (October 2015): [W]e cannot be certain about either the magnitude or the pace of … a recovery in the neutral real rate. 5

Conclusions of Laubach-Williams redux [N]o evidence that the [U.S.] natural rate has moved back up even with the economy close to fully recovered from the Great Recession. (Note: A long-run natural rate.) [N]o evidence that real interest rates are typically lower five years after a [financial] crisis …. Indeed, this time does appear to be different…. [L]ow real rates are the new normal. [E]pisodes of … zero lower bound are likely to be more frequent and longer…. Natural-rate point estimates have recently been 0 or below, almost half of decline ascribed to low potential GDP growth. 6

Advantages of a structural methodology Looking at long-term averages can get you only so far. For example, if inflation falls sharply, output could be below potential, and the actual real rate of interest above the natural rate. A structural model suggests that in these circumstances, average market rates may over-state the natural rate; e.g., Volcker disinflation. 7

The LW approach Unobserved (and hence estimated) values of: r* y* g* IS curve. Phillips curve. Euler/Ramsey equation linking r* and g*. Estimated using Kalman filter. Find ĉ = 1.3 = 1/σ = 1/0.77 8

10-year T bonds and real per capita consumption growth Low frequency correlations* 1960-2007: .48 1960-2014: .75 *Correlation at periodicities  12 years But in the short term, consumption growth explains little about real interest rates. Source: Calculations by James H. Stock, Harvard University 9

Conceptual issues: Open economy The global capital market has become more highly integrated. In principle the real interest rate should depend on global, not national, growth. The LW framework could allow for foreign influences on the IS or Phillips curves. “Standard” Clarida et al. version too restrictive. Could an extended framework give estimates of the equilibrium current account and real exchange rate? 10

International short-term rates coherence Global short-term real interest rates (percent) Interquartile range GDP-weighted interest rate Based 3m cpi previous \\data1\res\Bloomberg\PPT\2016\WEMD\1JAN\Data\Global_10yr_Real_ST.xlsx Australia Canada France Germany Italy Japan Netherlands New Zealand Norway Spain Sweden Switzerland United Kingdom United States Sep. 2015 Sources: IMF, Global Data Source; and Consensus Forecasts. Sample includes Australia, Canada, France, Germany, Italy, Japan, Netherlands, New Zealand, Norway, Spain, Sweden, Switzerland, United Kingdom, and United States. 11

Conceptual issues: Anchoring expectations A simplified framework would look like: These imply: So relatively high real rate implies deflation compared to the anchor inflation rate. Normally a Taylor-type rule would determine target inflation; but what happens at ZLB? 12

Global low inflation Headline CPI: Number of countries with low inflation rates (out of 55 countries) \\data1\res\Bloomberg\PPT\2016\WEMD\1JAN\Data\PCPI.xlsx Consists of: Australia Austria Belgium Canada Czech Republic Denmark Estonia Finland France Germany Greece Hong Kong SAR Ireland Israel Italy Japan Korea Latvia Lithuania Luxembourg Netherlands New Zealand Norway Portugal Singapore Slovak Republic Slovenia Spain Sweden Switzerland Taiwan Province of China United Kingdom United States Argentina Brazil Bulgaria Chile China Colombia Hungary India Indonesia Malaysia Mexico Pakistan Peru Philippines Poland Romania Russia South Africa Thailand Turkey Ukraine Venezuela Sep. 15 Sources: IMF, Global Data Source; and IMF staff calculations. 13

A few other issues/questions Standard errors on natural-rate estimates are large; would be useful to see them in these updates. Similarly for potential growth, output gap; is the point estimate for trend growth too high, given the low estimated real rate? Kiley (2015) suggests that additional controls in the IS equation matter (even for the closed-economy case) and imply a higher real-rate estimate. Why have real rates fallen? Explanations are not disjoint: Low growth expectations? Low aggregate demand – and if so, why? Demographics – a recent model by Carvalho, Ferrero, and Nechio (2015) links lower population growth to lower real rates. 14

Background Slides

International long-term rates coherence Global long-term real interest rates (quarterly, percent) Interquartile range GDP-weighted interest rate \\data1\res\Bloomberg\PPT\2016\WEMD\1JAN\Data\Global_10yr_Real_LT.xlsx Australia Canada France Germany Italy Japan Netherlands New Zealand Norway Spain Sweden Switzerland United Kingdom United States 2015Q3 Sources: IMF, Global Data Source; and Consensus Forecasts. Sample includes Australia, Canada, France, Germany, Italy, Japan, Netherlands, New Zealand, Norway, Spain, Sweden, Switzerland, United Kingdom, and United States. 16