Joint Research Program 2018

XXIII Meeting of the Central Bank Researchers Network

# The Natural Interest Rate in Emerging Economies

**Editors**

Ángel Estrada García

Iván Kataryniuk

About the Editors

Ángel Estrada García and Iván Kataryniuk

Preface

CEMLA

Introduction

Ángel Estrada García and Iván Kataryniuk

**Country Studies: Measurement of the Natural Interest Rate**

Assessing the
Usefulness
of
the Neutral Rate of Interest to Monetary Policy in Jamaica

Alexander Lee and Carey-Anne Williams

*Abstract*

Since the early 1990’s, the transmission mechanism of monetary policy in Jamaica has been extensively researched. Most of this research focused on the speed and the effectiveness of the transmission. This paper extends the existing research by focusing on estimating and assessing the usefulness of the neutral rate of interest to the conduct of monetary policy. While the concept of the neutral rate is well-grounded in theory, as an unobservable variable, there are several proposed methods of estimation. In this paper, we estimate the neutral rate for Jamaica using four methods commonly found in the literature. Based on these methodologies, the real neutral rate is estimated to range between -2.6% to 2.6%, or 2.4% to 7.6% in nominal terms. This implies that the Bank of Jamaica’s current monetary policy stance has been fairly accommodative given recent sub-optimal trends in inflation and growth.

Monetary
Policy
in
Costa Rica: An Assessment Based on the Neutral Real Interest Rate

Evelyn Muñoz-Salas and Adolfo Rodríguez-Vargas

*Abstract*

In this study we assess the monetary policy stance in Costa Rica during the 2009-2018 period using an indicator of the real policy rate gap. We obtain estimates of the real neutral interest rate by using six methodologies, whose empirical consistency is evaluated in order to decide whether they are used in the final estimation. The updated value for the real neutral interest rate is 1.54%. The policy rate gap indicator shows appropriate empirical properties, among them a negative lead correlation with the output gap and core inflation. This suggests that the policy rate is successfully influencing the marginal cost of liquidity for financial intermediaries. Our analysis suggests that monetary policy in Costa Rica has responded mainly to inflation movements not related to temporary shocks, and that some policy adjustments could have been swifter.

Long Term Neutral
Real
Interest
Rate for Honduras

Fredy Fernando Álvarez

*Abstract*

The purpose of this document is to present a first estimate of the Neutral or Natural Real Interest Rate (NRIR) for Honduras, which is defined as the unobservable interest rate consistent with the potential Gross Domestic Product (GDP) of an economy and with an unemployment rate that does not accelerate inflation (NAIRU); therefore serves as a reference for the analysis of the monetary policy stance of central banks. For its measurement, quarterly information is used for the 2005-2016 period, using several methodologies that although they differ in their approach, they do not present much variation in their results. On the other hand, because there is not a consensus on which is the most appropriate technique, the methodologies used for the estimations for Honduras are selected on the basis of the available information for the country. Therefore, the results are obtained using: the average of the ex ante real interest rate for a long period in which inflation behaved relatively stable; the Hodrick-Prescott (HP) filter to extract the trend of the real interest rate; and the Baxter and King filter (BK) to extract the cyclical element from a series. In addition, an estimate is obtained from the uncovered interest rate parity condition and from a semi-structural model using the Kalman filter adapted to the conditions of the Honduran economy. The estimates obtained from these different techniques reveal an average for the period analyzed for the Neutral Interest Rate in current values between 6.69% to 8.08% and in real values from 0.77% to 2.16%; similarly, it is found that in recent years the interest rate has shown a gradual decrease associated in part to a lower Monetary Policy Rate (MPR), combined with low levels of inflation and relatively stable economic growth.

Neutral
Rate
of
Interest: The Case of the Dominican Republic

José Manuel Michel

*Abstract*

The aim of this paper is to estimate the neutral rate of interest for the Dominican Republic. The methods used are reduced-form model, interest rate parity, and marginal product of capital. Empirical evidence provides evidence in favor of the interest rate parity hypothesis as a useful tool for estimating the neutral rate of interest. The results suggest that nominal and real neutral rates of interest have fallen following the 2008 financial crisis. The reduced-form model and interest rate parity methods tell us that the average nominal neutral rate of interest of the post-financial crisis period stands at between 5.5% and 6.2%. These same methods yield values between 1.0 and 1.4% for the real neutral rate of interest. The marginal product of capital method estimates a real neutral rate of interest of 3.6%.

The Natural
Rate
of
Interest: A Benchmark for the Stance of the Monetary Policy in Bolivia

Paul Estrada Céspedes and David Zeballos Coria

*Abstract*

The aim of this paper is to estimate Bolivia’s natural rate of interest considering quarterly data for the period 1996 - 2017 during which changes occurred in the economic climate, affecting monetary policy and possibly the natural rate of interest, in particular an accelerated and substantial de-dollarization and strongly expansionary monetary policy over the last few years. A semi-structural model developed by Laubach and Williams (2003) is estimated, defining the natural rate of interest as the real interest rate consistent with stable inflation and output at its natural rate. In keeping with Holston, Laubach and Williams (2016), the methodology is enriched by analyzing the natural rate of interest as a time-varying process using the Kalman filter. The results reveal changes over time in the natural rate of interest, mainly from 2006, including a drop in recent years. These results have implications for monetary policy decision-making.

**Country Studies: Long Run Determinants **

The Natural Rate of
Interest
for
an Emerging Economy: The Case of Uruguay

Elizabeth Bucacos

*Abstract*

Vast evidence indicates that the so-called natural rate of interest has experienced a sustained fall in both advanced and emerging economies over the last 25 years. This situation threatens the central bank’s ability to guide relevant macroeconomic variables close to their welfare-maximizing path because the range of maneuver is reduced a great deal when interest rates descend to the zero lower bound. In this document, I try to estimate the natural interest rate (NIR) for Uruguay, a small, open and dollarized emerging economy where monetary policy implementation has changed drastically, splitting the sample in two. The methodological approach is aimed at providing a novel framework for analyzing the long-run fundamentals of the NIR and also for explaining the reasons for short-run discrepancies between the real rate and its long-run equilibrium value. It is hoped that the fundamentals-based model adds to the myriad methods current in use at the Banco Central del Uruguay to estimate the NIR.

The Longer-Term
Convergence
Level of the Neutral Rate of Interest in Mexico

Julio A. Carrillo, Rocio Elizondo, Cid Alonso Rodríguez-Pérez, and Jessica
Roldán-Peña

*Abstract*

In this paper, we argue that foreign and domestic structural factors may explain the decline of the long-run convergence level of the neutral rate of interest in Mexico. In particular, we find that low-frequency changes in the neutral rate may be attributed to increasing domestic savings, demographics shifts, and a decreasing global long-run real interest rate. These results are largely consistent with other studies showing that the neutral rate has decreased in the last 25 years in advanced and emerging economies alike.

Measuring the
Output
Gap,
Potential Output Growth, and Natural Interest Rate from a Semi-Structural
Dynamic
Model
for Peru

Luis Eduardo Castillo and David Florián Hoyle

*Abstract*

In this paper we use a calibrated version of the Quarterly Projection Model (MPT, for its acronym in Spanish) to jointly estimate the output gap, potential output growth and natural interest rate of the Peruvian economy during most of the inflation targeting regime (between 2002 and 2017). The MPT is a semi-structural dynamic model used by the Central Reserve Bank of Peru for forecasting and policy scenario analysis. The model functions as a multivariate filter with a sophisticated economic structure that allows us to infer the dynamics of non-observable variables from the information provided by other variables defined ex ante as observable. As the results from the Kalman filter are sensible to these variables declared as observable, we use five groups of variables to be defined as such to build probable ranges for our estimates.

The results indicate that the estimated output gap is large in amplitude and highly persistent, while potential output growth is very smooth. Therefore, most of the variation in economic activity during the inflation targeting regime can be attributed to the former. As expected from a small open economy, a historical decomposition exercise shows that output gap dynamics are mainly influenced by external factors (real and financial). The estimation of the output gap also proves that monetary policy has been extensively responsive to this leading indicator of inflation. Meanwhile, the real natural interest rate is estimated to be considerable stable, averaging 1.6% in the sample with only a sharp decline to 1.3% during the financial crisis.

The main finding of the paper, however, is that there has been a steady deceleration of potential output growth since 2012. A growth-accounting exercise proves that this trend is mostly explained by a reduction in total factor productivity (TFP) growth during the same time frame. Nonetheless, the drop of capital and labor contributions jointly explain almost a third part of average potential output growth slowdown between 2010-2013 and 2014-2017.

**
Cross-Country Studies
**

The Natural
Interest
Rate
in Latin America

Javier G. Gómez-Pineda

*Abstract*

The natural interest rate is a critical building block in the evaluation of a monetary policy stance. We estimate the natural interest rate for the five largest Latin American economies. We follow the method in Laubach and Williams (2003), complemented with rational and survey inflation expectations and adapted to Bayesian maximum likelihood estimation. The model is the standard neo-Keynesian model, complemented with equations for the natural interest rate in nominal terms and the rational inflation expectations. We find that in real terms the natural interest rate trends down and remains above zero in the larger economies (Brazil, Mexico and Colombia), while it remains without a noticeable trend although closer to zero in the smaller economies (Chile and Peru). We also find that in nominal terms, the natural rate trends down, in most economies a consequence of the drop in inflation and inflation expectations. Regarding the policy implications, the natural interest rate still does not pose a critical challenge for monetary policy in Latin America, as it does in advanced economies (Ball 2014). Nonetheless, in Chile and Peru the natural rate in nominal terms is just above 2% and 3%, respectively, offering narrow room for expansionary monetary policy.

Common and
Idiosyncratic
Factors of Real Interest Rates in Emerging Economies

Ángel Estrada, Jesús Gonzalo, and Iván Kataryniuk

*Abstract*

In this paper, we attempt to model real interest rates in advanced and emerging economies. We rely on an open economy general equilibrium model (Clarida, 2017) to derive a cointegrating structure in interest rates for advanced and emerging economies. In this model, interest rates in an emerging economy would be the sum of a unit root process related to a global factor, another unit root process related to idiosyncratic factors and a stationary component. We account for these properties to estimate a global factor for emerging economies using the PANIC (2004) approach. The results show that a common factor is present in emerging economies, and it is very similar to the cointegrating factor in advanced economies, while the residuals in emerging economies are still unit root, thus validating the theory.