https://macropaperwarehouse.com/authors/sandra-daudignon/Sandra DaudignonHugo -- gohugo.ioen-ushttps://macropaperwarehouse.com/papers/monetary-policy-and-the-drifting-natural-rate-of-interest/https://macropaperwarehouse.com/papers/monetary-policy-and-the-drifting-natural-rate-of-interest/<p>This paper analyzes how monetary policy should respond to a long-run natural interest rate that can drift permanently — following a bounded random walk with upper bound 3 percent and lower bound 0 percent — when the zero lower bound (ZLB) on nominal interest rates is a binding constraint. The central result is that the long-run neutral rate (the real policy rate consistent with stable inflation in long-run equilibrium) should fall more than one-for-one with the long-run natural rate as the latter approaches zero, because the mere risk of future ZLB episodes — even when the economy is currently away from the ZLB — imparts a persistent downward bias on inflation expectations that can only be offset by maintaining a pre-emptive expansionary bias. Quantitatively, the model implies that the neutral rate should be zero as soon as the long-run natural rate falls to 75 basis points — well above the near-zero estimates prevailing in the late 2010s — and that the ZLB would bind one-third of the time under optimal policy when the natural rate fluctuates between 0 and 3 percent. Price level targeting with a 10-basis-point upward drift closely approximates optimal commitment policy and has the advantage of not requiring knowledge of the natural rate level.</p>