Robust Monetary Policy Rules with Unknown Natural Rates

The natural rate is an abstraction; like faith, it is seen by its works. One can only say that if the bank policy succeeds in stabilizing prices, the bank rate must have been brought in line with the natural rate, but if it does not, it must not have been.¹

The conventional paradigm for the conduct of monetary policy calls for the monetary authority to attain its objectives of a low and stable rate of inflation and full employment by adjusting its short-term interest rate instrument—in the United States, the federal funds rate—in response to economic developments. In principle, when aggregate demand and employment fall short of the economy's natural levels of output and employment, or when other deflationary concerns appear on the horizon, the central bank should ease monetary policy by bringing real interest rates below the economy's natural rate of interest for some time. Conversely, the central bank should respond to inflationary concerns by adjusting interest rates upward so as to bring real interest rates above the natural rate. In this setting, the natural rate of unemployment is the unemployment rate consistent with stable inflation; the natural rate of interest is the real interest rate consistent with unemployment being at its natural rate, and therefore with stable inflation.² In carrying out this strategy in practice, the policymaker would ideally have accurate, quantitative, contemporaneous readings of the natural rate of interest and the natural rate of unemployment. Under those circumstances, economic stabilization policy would be relatively straightforward.

However, an important difficulty that complicates policymaking in practice and may limit the scope for stabilization policy is that policymakers do not know the values of these natural rates in real time, that is, when they make policy decisions. Indeed, even in hindsight there is considerable uncertainty regarding the natural rates of unemployment and interest, and ambiguity about how best to model and estimate natural rates. Milton Friedman, arguing against natural rate-based policies in his presidential address to the American Economic Association, posited that "One problem is that [the policymaker] cannot know what the 'natural' rate is. Unfortunately, we have as yet devised no method to estimate accurately and readily the natural rate of either interest or unemployment. And the 'natural' rate will itself change from time to time."³ Friedman's comments echo those made decades earlier by John H. Williams and by Gustav Cassel, who wrote of the natural rate of interest: "The bank cannot know at a certain moment what is the equilibrium rate of interest of the capital market."⁴ Even earlier, Knut Wicksell stressed that "the natural rate is not fixed or unalterable in magnitude."⁵ Recent research using modern statistical techniques to estimate the natural rates of unemployment, output, and interest indicates that this problem is no less relevant today than it was 35, 75, or 105 years ago.

These measurement problems appear particularly acute in the presence of structural change, when natural rates may vary unpredictably, subjecting estimates to increased uncertainty. Douglas Staiger, James Stock, and Mark Watson document that estimates of a time-varying natural rate of unemployment are very imprecise.⁶ Orphanides and Simon van Norden show that estimates of the related concept of the natural rate of output (that is, potential output) are likewise plagued by imprecision.⁷ Similarly, Thomas Laubach and John C. Williams document the great degree of uncertainty regarding estimates of the natural rate of interest.⁸ These difficulties have led some observers to discount the usefulness of natural rate estimates for policymaking. William Brainard and George Perry conclude "that conventional estimates from a NAIRU [nonaccelerating-inflation rate of unemployment] model do not identify the full employment range with a degree of accuracy that is useful to policymaking."⁹ Staiger, Stock, and Watson suggest a reorientation of monetary policy away from reliance on the natural rate of unemployment, noting that

a rule in which monetary policy responds not to the level of the unemployment rate but to recent changes in unemployment without reference to the NAIRU (and perhaps to a measure...