Finance and Economics Discussion Series
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A key variable for the conduct of monetary policy is the natural rate of interest -- the real interest rate consistent with output equaling potential and stable inflation. Economic theory implies that the natural rate of interest varies over time and depends on the trend growth rate of output. In this paper we apply the Kalman filter to jointly estimate the natural rate of interest, potential output, and the trend growth rate, and examine the empirical relationship between these estimated unobserved series. We find substantial variation in the natural rate of interest over the past four decades in the United States. Our natural rate estimates vary about one-for-one with changes in the trend growth rate. We show that policymakers' mismeasurement of the natural rate of interest can cause a significant deterioration in macroeconomic stabilization.
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