Summary
Focus
Can a central bank raise interest rates and still see real (inflation-adjusted) rates immediately fall? If so, can we trust the gap between real interest rates and their natural level to be a reliable guide? I explore a puzzle that arises when moving from simple economic models to the larger, more realistic ones used by central banks. Adding factors like capital can cause real interest rates to behave in unexpected ways, challenging the idea that monetary policy works mainly through its effect on real interest rates. I use models, math and simulations to explain this puzzle and test its importance with real-world data.
Contribution
Understanding how monetary policy works and how to measure its impact is crucial for policymakers and researchers, especially during crises like pandemics, financial crashes or trade wars. These situations make it harder to interpret changes in the natural interest rate (r-star) and in the gap between real and natural rates. I offer a clear explanation of how central banks influence inflation during such times. I also introduce the state-invariant real interest rate gap, a better way to measure the stance of monetary policy and forecast inflation.
Findings
The puzzle arises when an evolving internal variable reacts strongly to a lasting and unexpected monetary policy change, causing inflation expectations to shift sharply. This makes the expected part of policy actions dominate, reversing the effect of the unexpected action. While the real interest rate channel still works, the gap does not show the true stance of policy. Using smoother policy rules helps, but fully solving the problem requires neutralising the effect of that evolving internal variable. Data from the United States (1965–2023) support the new measure’s effectiveness.
Abstract
Can a central bank tighten monetary policy and real interest rates fall under monetary dominance? Introducing endogenous capital into the New Keynesian model allows real interest rates to move in any direction at the impact of a positive persistent monetary policy shock. This raises concerns that the real interest rate channel is only observational – not structural – in these models. This paper demonstrates that the puzzle goes beyond capital. It emerges when the elasticity of an endogenous state variable to a persistent shock is high enough to sink inflation expectations, inducing the endogenous (or systematic) component of the monetary policy rule to sufficiently offset its exogenous component. The channel is indeed structural, but conventional definitions of the natural interest rate (r-star) and real interest rate gap can be misleading, particularly following events that significantly disrupt investment, such as pandemics, financial crises or trade wars. As an alternative sign-consistent gauge of the monetary policy stance, I propose the real interest rate gap that neutralizes the effect of shocks on endogenous state variables. From 1965Q1 to 2023Q3, it was often a better predictor of future inflation and helped telling the history of monetary policy in the United States.
JEL classification: E43, E52, E58
Keywords: monetary policy, new Keynesian model, natural interest rate
The views expressed in this publication are those of the authors and not necessarily those of the BIS.
