The Natural Rate of Interest Through the Hall of Mirrors

Abstract

We propose a novel explanation for persistent movements in the natural rate of interest (r-star) based on two-sided learning between the central bank and the private sector. We analyze a New-Keynesian model where both learn about r-star from each other. When both sides fail to recognise that their actions influence the other’s beliefs, a “hall-of-mirrors” effect arises that causes persistent shifts in r-star in response to cyclical shocks. The effect can explain the post-2008 decline in r-star even if longrun fundamentals had not changed. Conversely, a surge in inflation accompanied by monetary policy tightening can induce a persistent r-star increase.

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