Appendix 1. Figures
1 year ahead export demand index expectations (Blue line) vs actual export demand index realizations (red line). The export demand index is a combination of U.S. GDP growth and an exogenous AR(1) process with news shocks. Forecasts of U.S. GDP growth comes from the U.S. VAR block.
Values above (below) zero represents positive (negative) 1-year ahead news shocks on investment specific technology process. The blue line is a log-trend line.
Appendix 2. Data and Definitions
Adolfson, M., S. Laseen, J. Lindé, and L. Svensson, 2014, “Monetary Policy Trade-offs in an Open-Economy DSGE Model”, Journal of Economic Dynamics and Control, Volume 42, pp. 33–49.
Barsky, R., A Justiniano, and L. Melosi, 2014, “The Natural Rate and its Usefulness for Monetary Policy Making”, American Economic Review, Volume 104, Issue 7, pp. 37–43.
Campbell, J.Y., and J.H. Cochrane, 1999, “By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior”, The Journal of Political Economy, Volume 107, Issue 2, pp. 205–251.
Chetwin, W., and A. Wood, 2013, “Neutral Interest Rates in the Post-Crisis Period”, Reserve Bank of New Zealand Analytical Note Series No. 2013/07 (Wellington: Reserve Bank of New Zealand).
International Monetary Fund (IMF) (2014), World Economic Outlook April, 2014, “Prospective on Global Real Interest Rates,” Research Department paper (Washington).
Jaimovich, N., and S. Rebelo, 2009, “Can News about the Future Drive the Business Cycle?”, American Economic Review, Volume 99, Issue 4, pp. 1097–1118.
Justiniano, A., and B. Preston, 2010, “Monetary Policy and Uncertainty in an Empirical Small Open-Economy Model”, Journal of Applied Econometrics, Volume 25, Issue 1, pp. 93–128.
Laubach, T., and J. Williams, 2003, “Measuring the Natural Rate of Interest” Review of Economics and Statistics, Volume 85, Issue 4, pp. 1063–1070.
Poloz, S. 2014. “The Legacy of the Financial Crisis: What we know, and what we don’t.” Speech to the Canadian Council for Public-Private Partnerships (CCPPP), Toronto, Ontario, 3 November.
Mendes, R., 2014, “The Neutral Rate of Interest in Canada”, Bank of Canada Discussion paper No. 2014–5 (Ottawa: Bank of Canada).
Wilkins, C. 2014, “Monetary Policy and the Underwhelming Recovery.” Speech to the CFA Society Toronto, Toronto, Ontario, 22 September.
Prepared by Andrea Pescatori (WHD).
We will use the terms neutral and natural rate of interest interchangeably even though it is not appropriate to associate the term ‘neutral’ to an allocation of resources. This subtle difference between the two terms is, however, immaterial in the current context.
This range for medium-term neutral rates is in line with the Bank of Canada’s estimates obtained using several different approaches (see Mendes, 2014).
The natural rate is best described by the following popular citation: “There is a certain rate of interest on loans which is neutral in respect to commodity prices […] This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods” (Wicksell, 1898).
In relation to the literature, the most recent work that similarly adopts our definition of the neutral rate is Barsky and others (2014) for the United States. A seminal contribution, even though it relies on a more reduced-form backward-looking approach, is Laubach and Wiliams (2003).
This is particularly useful to understand the U.S. Federal Reserve’s decision to embark on unconventional monetary policy measures in the aftermath of the crisis: even though interest rates were at historically low levels, there was the clear perception that monetary policy was actually tight on the base of a substantially negative neutral rate.
Indeed, having the policy rate equal to the (nominal) neutral rate is a necessary but not sufficient condition for having both inflation and output gap stabilized around their desired levels.
A detailed description of the model and its estimation is available from the author upon request.
Physical capital and labor can be freely reallocated across firms.
The introduction of the Bank of Canada’s output gap reduces the risk that misspecification in the determination of the output gap affects the monetary policy reaction function.
See Jaimovich and Rebelo (2009), among many, for a description of the role of news shocks in driving business cycle.
A balanced-growth path requires using an inter-temporal elasticity of substitution of one.
The smoothed estimate of a variable x exploits all the available information in the sample; it is, thus, given by ETxt for t = 1, …, T.
The Canadian observable variables are the 3-month Treasury bill yield, CPI inflation, 1-year inflation expectations, GDP growth (excluding inventories, natural gas and oil), business investment growth, and non-energy export growth.
From a normative standpoint, Poloz (2014) argues that in the absence of this significant monetary stimulus in both Canada and the United States the output gap would have widened substantially.
Non-energy export expectations are a combination of the 4-quarter ahead U.S.-VAR forecast and news shocks on export demand.
We do not identify U.S. shocks specifically, so movements in U.S. rates will come along with the typical movements in output and inflation.
In the short run, exchange rate movements and the shock to the UIP allow Canadian and U.S. interest rates to deviate. In the long-run, however, the exchange rate is assumed to be constant. An interest rate differential arises only because of a non-zero, long-run net-foreign-asset position.
The estimates of the neutral rate abstract from the contribution of the oil sector to output growth which would likely mildly underestimate (overestimate) the neutral rate during the oil boom (bust) periods.