Natural rates and ‘starred’ variables: A conversation with Yellen, Reichlin, and Rajan

Central bankers often talk about the natural rate of interest (also referred to as the neutral rate of interest or r*) and the natural rate of unemployment (sometimes referred to as the non-accelerating inflation rate of unemployment, NAIRU or u*). The natural rate of interest is defined as the level of interest at which the Fed is neither stimulating nor restraining the economy, keeping it steady at full employment and stable inflation. The natural rate of unemployment is the lowest level that unemployment can reach without generating excess inflation.

In a conversation hosted by the Hutchins Center on Fiscal and Monetary Policy in mid-September, Janet Yellen, the former Federal Reserve chair who is now a Hutchins Center distinguished fellow; Lucrezia Reichlin of the London Business School, a former research director at the European Central Bank, and Raghuram Rajan of the University of Chicago, a former chief economist of the International Monetary Fund and governor of the Reserve Bank of India shared their views on these variables — often called ‘starred’ variables because economists use an asterisk to indicate that they are projected and estimated – and the uncertainty around them. (You can watch the full 60-minute video here).

Yellen discusses the benefits of using the natural rate of interest and unemployment in central bank communications

The former Fed Chair says that the natural rate of interest and natural rate of unemployment are important benchmarks when communicating the stance and future direction of monetary policy.

Yellen warns about uncertainty around estimates of natural rates

Yellen notes that while useful, the natural rate of interest and the natural rate of unemployment are inherently uncertain, and estimating them requires a degree of subtlety and humility.

Reichlin discusses resistance to ‘starred’ variables at the ECB

Reichlin says that in its early years, the ECB did not use so-called ‘starred’ variables when communicating the stance of monetary policy, in part due to their uncertainty. However, to increase the transparency of their economic forecasts, the ECB eventually did adopt these measures in its communications.

Rajan discusses estimating natural rates in emerging markets and the importance of data

Rajan stresses the importance of good data in measuring the economy and how central banks should use data to update their economic models and estimates of ‘starred’ variables.