The Impact of Climate Change on Estimates of Long Run Real Neutral Interest Rates

Abstract

This work aims to study how climate change risks could affect the financial system and how these dynamics are reflected in the convenience yield of the US Treasuries. More- over, it analyzes the implications of incorporating the convenience yield variable into the Holston-Laubach-Williams (HLW) model of the natural interest rate in the United States and in the Euro Area. The results yield four key findings. First, it is shown that the long-run dynamics of the convenience yield on U.S. Treasuries are influenced by the demand and supply of safe assets, financial risk indices and credit default risk indices, while the short- run dynamics are mainly affected by safe assets demand and market volatility dynamics. Second, natural interest rate estimations from the HLW model including the convenience yield are lower for both the US and Euro Area during periods of high convenience yield compared to the results from the original model by HLW. Third, the inclusion of the con- venience yield performs as a proxy of non-growth component of the natural interest rate, given that it reduces the z residual component for the US and in Euro Area estimations. Last, including this new variable in the HLW model gives more precise natural rate esti- mates.