Get the Lowdown: The International Side of the Fall in the U.S. Natural Rate of Interest

Abstract

Much consideration has been given among scholars and policymakers to the decline in the U.S. natural rate of interest since the 2007-09 global financial crisis. In this paper, I investigate its determinants and drivers through the lens of the workhorse two-country New Keynesian model that captures the trade and technological interconnectedness of the U.S. with the rest of the world economy. Using Bayesian techniques, I bring the set of binding log-linearized equilibrium conditions from this model to the data, but augmented with survey-based forecasts in order to align the solution with observed expectations incorporating the macro effects of the zero-lower bound constraint. With this structural framework, I recover a novel open-economy estimate of the U.S. natural rate. The paper's main results are: (a) the decline in the U.S. natural rate largely follows the slide of the longrun real interest rate in the forecast data, but is partly cushioned in the short run by the contribution of domestic and to a significant extent also foreign productivity shocks; (b) the fall of U.S. measured labor productivity during this time contributed to a concomitant fall in U.S. output potential; (c) the past decade is also characterized by the compression of markups (negative cost-push shocks) which accounts for much of the cyclical upswing in U.S. output in spite of the fall in its potential; and (d) monetary policy has shown its efficacy boosting U.S. output and sustaining U.S. inflation close to its 2 percent target against the drag on inflation from the negative cost-push shocks during this time. Finally, I also argue that ignoring the international linkages may result in biased estimates and can distort the empirical inferences on U.S. monetary policy in important ways.