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The informational content of empirical measures of real interst rate and output gaps for the United Kingdom

In: Monetary policy in a changing environment

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Author Info

  • Jens D J Larsen

    (Bank of England)

  • Jack McKeown

    (Bank of England)

Abstract

In many economies, the monetary policy instrument is the level of short-term nominal interest rates, but the monetary policy stance might be better characterised by the ex-ante real interest rate that this nominal rate implies, relative to some 'neutral' or 'natural' real rate of interest. In this paper, the natural rate of interest and the real interest rate gap - the difference between the actual and the natural real rate of interest - are estimated by applying Kalman filtering techniques to a small-scale macroeconomic model of the UK economy. In this model, the real interest rate gap, the output gap and inflation are related via IS-curve and Phillips-curve relationships. The natural rate of interest is defined as the level of (ex-ante) real interest rates that is consistent with an output gap of zero, that is output at its natural level, in the medium term. Based on these estimates, the paper examines whether empirical measures of the real interest rate gap are a useful tool for policymakers - do they contain additional information relative to the estimated output gap, and does the real rate gap have leading indicator properties for the output gap and inflation? Are these gap estimates of practical use in a policy setting? The paper finds that the real rate gap has leading indicator properties for both the output gap and inflation. Importantly, these properties have varied considerably over time: breaking the sample into four subsamples, it appears that the leading indicator properties for both the output and real rate gap were substantially stronger for the subsample that covers most of the 1980s. After the introduction of the inflation target, post 1992, the relationship between the real interest rate gap and the output gap strengthens, but the leading indicator properties of these gaps for inflation diminish, as might be expected under an inflation-targeting regime.

(This abstract was borrowed from another version of this item.)

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This chapter was published in:

  • Bank for International Settlements, 2003. "Monetary policy in a changing environment," BIS Papers, Bank for International Settlements, number 19, May.
    This item is provided by Bank for International Settlements in its series BIS Papers chapters with number 19-19.

    Handle: RePEc:bis:bisbpc:19-19

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    References

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    1. Katharine S. Neiss and Edward Nelson, 2001. "The Real Interest Rate Gap as an Inflation Indicator," Computing in Economics and Finance 2001 145, Society for Computational Economics.
    2. Bennett T. McCallum & Edward Nelson, . "Performance of Operational Policy Rules in an Estimated Semi-Classical Structural Model," GSIA Working Papers 1998-22, Carnegie Mellon University, Tepper School of Business.
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    4. Nelson, Edward & Nikolov, Kalin, 2004. "Monetary Policy and Stagflation in the UK," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 36(3), pages 293-318, June.
    5. Svensson, Lars E.O. & Rudebusch , Glenn, 1998. "Policy Rules for Inflation Targeting," Seminar Papers 637, Stockholm University, Institute for International Economic Studies.
    6. Jennifer V Greenslade & Richard G Pierse & Jumana Saleheen, 2003. "A Kalman filter approach to estimating the UK NAIRU," Bank of England working papers 179, Bank of England.
    7. Thomas Laubach and John C. Williams, 2001. "Measuring the Natural Rate of Interest," Computing in Economics and Finance 2001 35, Society for Computational Economics.
    8. Holland, Allison & Scott, Andrew, 1998. "The Determinants of UK Business Cycles," Economic Journal, Royal Economic Society, vol. 108(449), pages 1067-92, July.
    9. Watson, Mark W., 1986. "Univariate detrending methods with stochastic trends," Journal of Monetary Economics, Elsevier, vol. 18(1), pages 49-75, July.
    10. Hunt, Benjamin & Rose, David & Scott, Alasdair, 2000. "The core model of the Reserve Bank of New Zealand's Forecasting and Policy System," Economic Modelling, Elsevier, vol. 17(2), pages 247-274, April.
    11. Kuttner, Kenneth N, 1994. "Estimating Potential Output as a Latent Variable," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(3), pages 361-68, July.
    12. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc.
    13. Stock, James H. & Watson, Mark W., 1999. "Forecasting inflation," Journal of Monetary Economics, Elsevier, vol. 44(2), pages 293-335, October.
    14. Benati, Luca, 2008. "Investigating inflation persistence across monetary regimes," Working Paper Series 0851, European Central Bank.
    15. Smets, Frank & Wouters, Raf, 2002. "An estimated stochastic dynamic general equilibrium model of the euro area," Working Paper Series 0171, European Central Bank.
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    Cited by:
    1. Ansgar Belke & Jens Klose, 2010. "(How) Do the ECB and the Fed React to Financial Market Uncertainty?: The Taylor Rule in Times of Crisis," Discussion Papers of DIW Berlin 972, DIW Berlin, German Institute for Economic Research.
    2. A. Jung, 2013. "Policymakers’ Interest Rate Preferences: Recent Evidence for Three Monetary Policy Committees," International Journal of Central Banking, International Journal of Central Banking, vol. 9(3), pages 150-197, September.
    3. Juan José Echavarría & Enrique López Enciso & Martha Misas Arango & Juana Tellez Corredor, 2006. "La Tasa de Interés Natural en Colombia," BORRADORES DE ECONOMIA 003088, BANCO DE LA REPÚBLICA.
    4. Ansgar Belke & Jens Klose, 2012. "Modifying Taylor Reaction Functions in Presence of the Zero-Lower-Bound: Evidence for the ECB and the Fed," Discussion Papers of DIW Berlin 1218, DIW Berlin, German Institute for Economic Research.
    5. Ronny Mazzocchi, 2013. "Scope and Flaws of the New Neoclassical Synthesis," DEM Discussion Papers 2013/13, Department of Economics and Management.
    6. Humala, Alberto & Rodríguez, Gabriel, 2009. "Estimation of a Time Varying Natural Interest Rate for Peru," Working Papers 2009-009, Banco Central de Reserva del Perú.
    7. Mésonnier, J-S., 2006. "The Reliability of Macroeconomic Forecasts based on Real Interest Rate Gap Estimates in Real Time: an Assessment for the Euro Area," Working papers 157, Banque de France.
    8. Jean-Stéphane MESONNIER, 2007. "The predictive content of the real interest rate gap for macroeconomic variables in the euro area," Money Macro and Finance (MMF) Research Group Conference 2006 102, Money Macro and Finance Research Group.
    9. Julien Garnier & Bjørn-Roger Wilhelmsen, 2005. "The natural real interest rate and the output gap in the euro area: A joint estimation," Working Paper 2005/14, Norges Bank.
    10. Christian Bustamante & Luis E. Rojas, 2012. "Constant-Interest-Rate Projections and Its Indicator Properties," BORRADORES DE ECONOMIA 009383, BANCO DE LA REPÚBLICA.
    11. Mésonnier, J-S. & Renne, J-P., 2004. "A Time-Varying Natural Rate for the Euro Area," Working papers 115, Banque de France.
    12. Anna Piretti & Charles St-Arnaud, 2006. "Launching the NEUQ: The New European Union Quarterly Model, A Small Model of the Euro Area and U.K. Economies," Working Papers 06-22, Bank of Canada.
    13. Ronny Mazzocchi, 2013. "Monetary Policy when the NAIRI is unknown: The Fed and the Great Deviation," DEM Discussion Papers 2013/16, Department of Economics and Management.

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