But the editor cut it, leaving it "for future research." What's Past is Prologue Fast forward a decade, and an entirely new question about r-star arose: Why had estimates of r-star fallen so low? It's a topic Thomas and I explored in our "Redux" paper.8 And in 2017, Kathryn, Thomas, and I expanded the set of economies for which we estimated r-star.9 Indeed, before the pandemic, historically low estimates of r-star characterized advanced economies across the globe. This is illustrated by the Holston-Laubach-Williams (HLW) estimates of r-star for the United States and the Euro Area using data through 2019, shown in Figure 1. Both were around ½ percent before the onset of the pandemic, far lower than estimates from preceding decades. Back to the Future One of the features of the LW and HLW models is that both are designed to be flexible and to "let the data speak" in measuring changes in the natural rate of interest. Even this flexibility, however, has its limits. And the economic turmoil brought on by the COVID-19 pandemic went far beyond what the models were originally designed for. In particular, the pandemic violated two key assumptions about the nature of macroeconomic disturbances underlying the models.10 First, the Kalman filter statistical method that serves as the models' workhorse assumes random disturbances to the economy follow a normal, or bell-shaped, distribution. Relative to historical experience, COVID-19 represented an extremely rare tail event in terms of its effect on the economy.
At the end of 2022, the COVID-adjusted level of potential output (the black line) is 4.2 percent below the pre-pandemic projection for the fourth quarter of 2022, with nearly half of that shortfall explained by the COVID shock measure and the remainder a permanent change in the natural level of output (the gold line). In summary, according to the model estimates, the main longer-term consequence from the pandemic period is a reduction in potential output, but the imprint on r-star appears to be relatively modest. Importantly, there is no evidence that the era of very low natural rates of interest has ended. The Future of R-star? These estimates indicate that r-star today is about where it was before the pandemic. But where is it headed in the future? Of course, this is impossible to know with any certainty. One way to gauge how forecasters perceive the future of r-star is to use forecast data to estimate it. Figure 5 shows the HLW-based estimates of r-star in the U.S. through the end of 2024. It uses published data in the first quarter of 2023. The May 2023 Blue Chip forecasts for inflation, GDP, and interest rates are used as proxies for data from the second quarter of 2023 through the fourth quarter of 2024. The resulting estimate of r-star is about ½ percent in the first quarter of 2023, and subsequently falls to slightly below zero. Evidently, the value of r-star implied by private forecasts is, if anything, even lower than today's estimate.