While NY Fed President Williams recently argued that “there is no evidence that the era of low natural rates of interest has ended,” (which many including myself would say is not accurate), other analysts at the NY Fed who oversee its “Dynamic Stochastic General Equilibrium” (DSGE) model suggest otherwise, at least for the “short-run” measure of the natural rate of interest, or “r-star.” In a recent post on the Liberty Street Economics blog, economists Katie Baker, Logan Casey, Marco Del Negro, Aidan Gleich, and Ramya Nallamotu discuss some of the reasons why their DSGE’s estimate of the short-run natural rate of interest (in inflation-adjusted terms) increased from 0.81% in December 2022 to an eye-popping 3.57% in March 2023. (The post is available at The Evolution of Short-Run r* after the Pandemic) The latest results from the DSGE model project that r-star will decline to 2.22% at the end of 2023, 1.77% at the end of 2024, and 1.47% at the end of 2025.
Here is the last paragraph in the blog (my bold).
“In sum, to make sense of recent developments in the U.S. economy, we must explain the fact that the economy remains quite strong in spite of the FFR being more than 500 basis points higher than it was a little more than a year ago. The model rationalizes these developments by postulating that the short-run natural rate of interest has increased considerably over the past year. This, in turn, has implications for the speed of the decline of inflation toward the FOMC’s long run goal and for assessing the stance of monetary policy.”
Now I’m not a big fan of DSGE models, and I’m certainly not a big fan of the HLW model that was the basis for NY Fed Governor Williams’ assertion that there is no evidence that the natural rate of interest has increased meaningfully, if at all. There are, however, many reasons to believe that the natural rate of interest HAS in fact increased significantly, including but not limited to market-based signals.
Not surprisingly, of course, market participants are quite uncertain as to “the Fed’s” current view is on the “natural” rate of interest, as there is conflicting evidence not just within the NY FED but from research at other regional Federal Reserve Banks.
Some are hoping that the Fed Chairman Powell may address the “r-star issue” at Jackson Hole this week, or at least express his views on this issue, though given the conflicting evidence I’m not sure whether he will provide much clarity save that the level of r-star is “highly uncertain” – which is certainly the case!
But I think there is a strong case that the “natural” rate of interest is back to levels just prior to the 2008 financial crisis.