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Bond MarketBIS r* Paper

BIS r* Paper

The BIS Quarterly Review had a recent paper on r* (the preferred term for the “natural rate of interest”) by Benigno, Gianluca, Boris Hofmann, Galo Nuño Barrau, and Damiano Sandri. “Quo vadis, r*? The natural rate of interest after the pandemic.

This paper is an example of why I have largely given up on the DSGE literature. From my perspective, the contents may be summarised as:

  1. The authors describe r*, which is a necessary empirical complement to the dynamic stochastic general equilibrium (DSGE) literature. The DSGE literature assumes that the policy rate (and its expected path) are a key driver to macroeconomic dynamics. The value of r* is required to both assess the accuracy of the models, as well as to provide a guidepost to policy.

  2. They then look at a variety of estimates of r*, and note that they have all moved dramatically as a consequence of the pandemic and the monetary policy response to it.

  3. They discuss various theories as to why r* may have gone up, or possibly down.

  4. They then note that the uncertainty about r* should be taken into account when looking at policy.

The article is about a readable a summary of the topic as one would hope to find, and has 40 references (some recent, but many older ones that discuss r* estimation techniques). It has pretty graphs showing the evolution of r* estimates. For those interested in the topic, it isa good place to start.

My Concerns

Beyond noting that the article is a good summary, I will not dwell too much on it. The reason is straightforward: despite the breadth of the survey of papers that I have not bothered reading, it contained no information that I would consider to be new to me. Unfortunately for readers familiar with my writing, this means that the rest of this article is also entirely predictable.

The problem is straightforward: the entire DSGE literature is now premised on the assumption that there is no alternative way to look at macroeconomics. The core assumptions of DSGE macro must be close to correct, although there is an acceptance that existing models need new mathematical bells and whistles to reach a state of modelling nirvana. That is, it is possible to object to portions of standard DSGE models, but the “correct” model has to have similar properties (at least with respect to interest rates). As such, the macroeconomy must react to the real policy rate in such a way that it is possible to estimate r*, r* will evolve in an intelligible fashion, and that policymakers equipped with an accurate estimate of r* will evolve as they expect.

My counter-argument is that the most parsimonious view of macroeconomics is that the economy does not react to interest rates in the way that is conventionally assumed. So long as macro variables are not swinging wildly — which is most of the time, outside crises — any econometric method of estimating r* will converge to something resembling a moving average of the real policy rate. And since the policy rate is set by convention — not some natural law — any estimated value of r* just tells us about the historical trajectory of policymaker conventions. This is useful for those who spend their days guessing where the policy rate might end up, but that does not necessarily translate into being able to guess where the economy might evolve.

One does not need a doctorate in economics to understand why my proposition was not embraced by the numerous mainstream luminaries cited in the paper, only a cynical understanding of institutional psychology. None of them are going to be willing to commit to a position that says that the intellectual edifice that they spent almost their entire adult lives developing is entirely worthless and needs to be scrapped. And since embracing DSGE macro is a necessary step to advance in elite institutions, do not hold your breath waiting for a so-called “paradigm shift.”

If I had the time to dissect the paper, I would have been happy to do so. I do not have the time at present, so I just wanted to point out the existence of the article, and did my stock response.

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(c) Brian Romanchuk 2024


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