Monetary policy shocks affect neutral rate but not its long-term decline
A Bank of Canada staff working paper finds that monetary policy shocks significantly affect the neutral rate of interest and trend GDP growth. Contractionary shocks reduce the neutral rate, though their overall contribution to its long-term decline is modest.
Rethinking the neutral rate's immunity
The real neutral rate of interest (r*t) has been a central input to monetary policy analysis, traditionally viewed as insulated from policy due to assumptions of transitory effects on economic activity.
However, growing evidence challenges this, suggesting monetary policy can generate persistent effects on output, productivity, and innovation.
This paper contributes by developing a Trend-Cycle Bayesian Vector Autoregression (TC-BVAR) that jointly estimates r*t and assesses the impact of monetary policy shocks.
A key innovation is that cyclical shocks, notably monetary policy shocks, can affect the trend of macroeconomic variables, providing a way to assess whether transitory disturbances have persistent effects.
Using external instruments, the authors find that contractionary shocks reduce r*t and lower trend GDP growth.
This finding reinforces the recent view that monetary policy can shape macroeconomic outcomes beyond business-cycle frequencies, influencing the dynamics of r*t.
Modest role in long-term shifts
While monetary policy shocks at times generate notable fluctuations in r*t—particularly during recessions—their contribution to its long-term downward trend is limited.
Aggregated over the full sample, monetary policy shocks make a small but positive net contribution to r*t, suggesting they may have prevented further declines but are not the primary driver of the secular trend.
The framework yields r*t estimates broadly consistent with standard benchmarks, fluctuating between 2 and 2.5 percent before the global financial crisis and declining toward 1 percent thereafter.
The study suggests the effect of monetary policy shocks on r*t operates more through real-economy channels, such as endogenous growth or hysteresis, than through financial-market channels like the term premium.
Nuanced challenge to orthodoxy
This paper offers a crucial methodological advancement by jointly estimating the neutral rate and monetary policy shocks, directly addressing a long-standing debate.
While it definitively shows policy shocks affect the neutral rate, its finding of a modest contribution to the secular decline provides a necessary tempering of expectations.
The study thus refines our understanding, highlighting that while monetary policy is not entirely benign, other structural forces remain dominant for long-term trends.