The natural rate of interest through a hall of mirrors

BIS Working Papers  |  No 974  | 
02 November 2021
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 |  49 pages



Why have global real interest rates fallen so much? A common explanation is that factors such as shifting demographics and falling potential growth depress the natural interest rate, or r-star. This view has striking policy implications: central banks have no choice but to lower interest rates to keep their economies in balance. After all, they cannot control the natural interest rate. Extraordinary monetary policy and recent policy framework reviews can be seen as part of the strategy to combat the decline in r-star.


Our new hypothesis links the fall in real interest rates to monetary policy itself. We employ the standard New Keynesian framework, but assume that information about the drivers of r-star is incomplete. The central bank learns about r-star from macroeconomic outcomes, while the private sector also learns from the central bank's policy actions. This simple and realistic model ties r-star to a learning process, which in our setup is shaped by how the central bank conducts its policy.


We show that the natural interest rate can decline persistently even if there is no change in saving preferences or potential growth. The driving force is a positive learning feedback. The private sector interprets monetary policy easing as a signal from the central bank that the natural rate has fallen, leading to a lower aggregate demand than otherwise. The central bank interprets lower demand as a sign of falling r-star and cuts the policy interest rate, perpetuating the misperception. Both sides stare into a "hall of mirrors" and confuse the effects of their own actions with useful information. We calibrate the model and show that the hall of mirrors effect can explain most of the fall in real interest rates since the Great Financial Crisis.


Prevailing justifications of low-for-long interest rates appeal to a secular decline in the natural interest rate, or r-star, due to factors outside monetary policy's control. We propose informational feedback via learning as an alternative explanation for persistently low rates, where monetary policy plays a crucial role. We extend the canonical New Keynesian model to an incomplete information setting where the central bank and the private sector must learn about r-star and infer each other's information from observed macroeconomic outcomes. An informational feedback loop emerges when each side underestimates the effect of its own action on the other's inference, leading to large and persistent changes in perceived r-star disconnected from fundamentals. Monetary policy, through its influence on the private sector's beliefs, endogenously determines r-star as a result. We simulate a calibrated model and show that this 'hall of mirrors' effect can explain much of the decline in real interest rates since 2008.

Keywords: natural rate of interest, learning, misperception, overreaction, dispersed information, long-term rates, demand shocks, monetary policy shocks.

JEL classification: E43, E52, E58, D82, D83.