The Capital Puzzle by Eduardo G. C. Amaral published by BIS (8/2025).
Can a central bank tighten monetary policy and real interest rates fall under monetary dominance? Introducing endogenous capital into the New Keynesian model allows real interest rates to move in any direction at the impact of a positive persistent monetary policy shock. This raises concerns that the real interest rate channel is only observational — not structural — in these models. This paper demonstrates that the puzzle goes beyond capital. It emerges when the elasticity of an endogenous state variable to a persistent shock is high enough to sink inflation expectations, inducing the endogenous (or systematic) component of the monetary policy rule to sufficiently offset its exogenous component. The channel is indeed structural, but conventional definitions of the natural interest rate (r-star) and real interest rate gap can be misleading, particularly following events that significantly disrupt investment, such as pandemics, financial crises or trade wars. As an alternative sign-consistent gauge of the monetary policy stance, I propose the real interest rate gap that neutralizes the effect of shocks on endogenous state variables. From 1965Q1 to 2023Q3, it was often a better predictor of future inflation and helped telling the history of monetary policy in the United States.
