Measuring the Natural Rate of Interest after COVID-19
with Thomas Laubach and John C. Williams
Federal Reserve Bank of New York Staff Reports, no. 1063, 2023
We estimate the natural rate of interest—the real short-term interest rate consistent with economic output equaling its natural rate and constant inflation—for the United States, Euro Area, and Canada following the COVID-19 pandemic. To do so, we introduce time-varying volatility and add a persistent supply shock to the Holston-Laubach-Williams and Laubach-Williams models of the natural rate of interest to address the extraordinary effects of the COVID-19 pandemic on the economy. These two extensions are necessary to account for the extreme magnitude and nature of the demand and supply shocks associated with the pandemic, which violate key model assumptions. This problem is not unique to our models, and we propose a general solution that can be applied to estimate other unobserved variables after extreme shocks. Resulting estimates of the natural rate of interest in the second quarter of 2023 are close to their respective levels estimated directly before the pandemic; that is, we do not find evidence that the era of historically low estimated natural rates of interest has ended. In the context of our model, the main consequence from the pandemic period was a reduction in estimated natural rates of output.