The global factor in neutral policy rates: Some implications for exchange rates, monetary policy, and policy coordination

• Date: 01 May 2019
• Published date: 01 May 2019
• Author: Richard Clarida
• DOI: http://doi.org/10.1111/infi.12345

Received: 19 June 2018

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Revised: 28 December 2018

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Accepted: 3 January 2019

DOI: 10.1111/infi.12345

ORIGINAL ARTICLE

The global factor in neutral policy rates: Some

implications for exchange rates, monetary

policy, and policy coordination

Richard Clarida

1,2

*

1

Department of Economics, Columbia

University, New York City, New York

2

Board of Governors of the Federal

Reserve System, Washington, DC

Correspondence

Richard Clarida, Board of Governors of

the Federal Reserve System, 20 Street and

Constitution Avenue, NW, Washington,

DC 20551.

Email: rhc2@columbia.edu

Abstract

This paper highlights some of the theoretical and

practical implications for monetary policy and exchange

rates that derive specifically from the presence of a

global general equilibrium factor embedded in neutral

real policy rates in open economies. Using a standard

two‐country Dynamic Stochastic General Equilibrium

(DSGE) model, we derive a structural decomposition in

which the nominal exchange rate is a function of the

expected present value of future neutral real interest rate

differentials plus a business cycle factor and a purchas-

ing power parity (PPP) factor. Country‐specific “r*”

shocks in general require optimal monetary policy to

pass these through to the policy rate, but such shocks

will also have exchange rate implications, with an

expected decline in the path of the real neutral policy

rate reflected in a depreciation of the nominal exchange

rate. We document a novel empirical regularity between

the equilibrium error in the Vector Error Correction

Model (VECM) representation of the empirical Holston,

Laubach, and Williams (HLW) four‐country r* model

and the value of the nominal trade weighted dollar. In

fact, the correlation between the dollar and the 12‐

quarter lag of the HLW equilibrium error is estimated to

International Finance. 2019;22:2–19. wileyonlinelibrary.com/journal/infi © 2019 John Wiley & Sons Ltd

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2

*The views expressed in this article are those of the author and do not necessarily reflect the position of the Board of

Governors of the Federal Reserve System or the Federal Reserve System.

be 0.7. Global shocks to r* under optimal policy require

no exchange rate adjustment because passing though r*

shocks to policy rates “does all the work”of maintaining

global equilibrium. We also study a richer model with

international spillovers so that in theory there can be

gains to international policy cooperation. In this richer

model, we obtain a similar decomposition for the

nominal exchange rate, but with the added feature that

r* in each country is a function of global productivity

and business cycle factors even if these factors are

themselves independent across countries. We argue that

in practice, there could well be significant costs to

central bank communication and credibility under a

regime of formal policy cooperation, but that gains to

policy coordination could be substantial given that r*s

are correlated across countries.

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INTRODUCTION

Over the past 25 years, best‐practice monetary policy has been implemented with reference to

interest rate feedback rules that include as inputs estimates of potential output and the real

policy rate—consistent with price stability. Before the global financial crisis and reflecting the

justly deserved influence of Taylor (1993), it was common in policy simulations (Henderson &

McKibbin, 1993) and in empirical work (Clarida, Galí, & Gertler [CGG], 1998, 2000) to make

the simplifying assumption that r* is constant. However, it has long been appreciated

(Friedman, 1968; Wicksell, 1898) that r* can be time‐varying and in particular, the theoretical

analysis of monetary policy rules in Woodford (2003) and CGG (1999, 2002)—among many

others—has emphasized that shocks to r* should be reflected in policy rates set by central banks

seeking to keep the economy as close as possible to the benchmark of a flexible price

equilibrium. Since the global financial crisis, estimated and projected future declines in neutral

real policy rates (Hamilton, Ethan, Hatzius, & West, 2016; Holston, Laubach, & Williams

[HLW], 2017; Laubach & Williams, 2003) relative to the precrisis experience have become an

important consideration in the conduct of monetary policy and the communication of forward

guidance at the Fed and some other major central banks (Haldane, 2015; Yellen, 2017).

The focus of this paper is on highlighting some of the theoretical and practical implications

for monetary policy and foreign exchange rates that derive specifically from the presence of a

global factor—predicted in theory and estimated in practice—embedded in neutral real policy

rates in open economies.

After reviewing in Section 2 some of the existing empirical evidence on the presence of a

global factor in neutral policy rates, we present in Section 3 a simple two‐country model (based

on Clarida, 2014; Galí & Monacelli, 2005) to help illustrate several points about how shocks to

neutral policy rates might impact monetary policy and exchange rates. We show that in this

model, the short‐run neutral real policy rate in each country will be a function of expected

productivity growth in that country, so that if there is a common factor across countries in

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CLARIDA