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| The Natural Interest Rate Puzzle in China and Bond Market Pricing: Insights from A Macro-finance Model |
| WANG Bo, CHEN Kaipu
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| School of Finance, Nankai University |
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Abstract The natural interest rate is an important concept in macroeconomics and finance, as it provides a benchmark for calibrating the stance of monetary policy. It also affects the price of financial assets and the allocation of large categories of assets by affecting the discount rate in the financial market. However, the natural interest rate is unobservable and is thus estimated in the macroeconomic literature and the financial literature using various methods. An implicit assumption of the finance-based approach is that the financial market is efficient . This implies that additional economic and financial information is needed to jointly predict future trends in interest rates and estimate the natural interest rate. Macro-based estimates of the natural interest rate are heavily dependent on the assumptions of the models used, which often omit important variables. The discrepancy between the natural interest rate estimated using financial methods and that estimated using macroeconomic methods is termed the “natural interest rate puzzle.” This study finds key evidence for such a discrepancy in China and this discrepancy could lead to disturbances in the formulation of monetary policy, which requires a more accurate estimate of the natural interest rate than those that are currently used.
In this study, we estimate China's natural interest rate using a financial model and a macroeconomic semi-structural model, and confirm that China also faces the natural interest rate puzzle. We solve the puzzle by constructing a consistent macro-finance model that estimates the natural interest rate by utilizing both macroeconomic variables and yield curve information. The interest rate and the natural interest rate represent an important intersection of macroeconomics and finance research. Specifically, not only do the yield curve and other financial variables have an important impact on the estimation of the natural interest rate, but the accurate estimation of the natural interest rate has an important impact on asset pricing. Identifying the factors influencing bond yields and combining macroeconomics and finance factors are important trends in bond pricing research. Macro-finance theory shows that the trend of inflation and the natural interest rate are the basic determinants of the yield curve. Under the macro-finance framework, we further study the impact of the natural interest rate on bond pricing. We obtain yield data from the CCDC, and use the quarterly values of monthly year-on-year CPI data as the inflation rate. We take the first quarter of 2011 as the base period, and obtain the value of real GDP from the nominal GDP and GDP year-on-year growth rate and quarter-on-quarter growth rate, which are logarithmically processed and seasonally adjusted by X-13. The data are acquired from the Wind Economic Database and CEIC database.
The results lead to two conclusions. (1) The macro-finance model could solve China's natural interest rate puzzle, and estimates a lower natural interest rate than that estimated by the macroeconomic model. (2) The natural interest rate has a significant impact on bond yields. Adding the natural interest rate can improve the goodness-of-fit of bond yields to the yield curve across a range of maturities.
An important contribution we make in this study is to apply the framework of Brand et al. (2020) to solve a theoretical problem—the natural interest rate puzzle—and expand the application of this method by incorporating fundamental information on China's interest rate liberalization reform. We also empirically test the important role of the consistent natural interest rate that we estimate in describing the dynamics of the bond yield.
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Published: 02 July 2022
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