We hit it off immediately. It just so happened that both of us had been thinking about the natural rate of interest. And since Governor Meyer had raised the subject, we moved quickly to develop an approach to answer his questions. Although we didn't know it then, we were following exactly the problem the other John Williams laid out in 1931.3 Simply put, Thomas had a hammer. And we found a new nail. The hammer was the Kalman filter, which is about inferring the behavior of an object from its effects on other objects. And the nail was r-star. A Fast Start On December 14, 2000, after a few short months of working together, we wrote our ideas and results in a memo to the Board of Governors.4 The memo started with the bold declaration: "This memo is a first report on a broader project to study alternative definitions and estimates of the equilibrium real rate (R*) and to evaluate their usefulness in the conduct of monetary policy." And the Laubach-Williams (LW) model was born. Starting in May 2001, r-star estimates made their way into the staff Bluebook prepared for the FOMC.5 Looking back, I am struck by how quickly these ideas came together. I must also acknowledge the unwavering support we received from senior leadership to bring this new research to policymakers. Within a year of writing the memo, we put out the academic version of this work.6,7 The original paper included a section on timevarying r-star's implications for monetary policy.
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.