Estimation of the natural interest rate under monetary policy smoothing

A strand of recent literature embeds central bank reaction functions into unobserved components (UC) models to estimate the natural rate of interest (NRI). These studies use inertial Taylor-type monetary policy rules linking the cyclical component of the interest rate to inflation and the output gap. In this paper we demonstrate that this avenue of measuring the NRI may lead to inappropriate trend-cycle decompositions and potential omitted variable problems. As an alternative we suggest taking account of the interest rate smoothing objective inherent in most specifications of central bank reaction functions only, rather than resorting to any specific form of Taylor-type rule. We go on to incorporate the steady-state policy rate implied by the smoothing objective into a version of the Holston–Laubach–Williams (HLW) model. We confirm the role of policy smoothing in impacting the latent variables of the model. In particular, we obtain generally lower estimates of the NRI, while the output gap turns out to track the CBO output gap much better than the HLW model itself. Our results turn out to be robust with different calibrated smoothing parameters.