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Output gaps, inflation and financial cycles in the UK

Author

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  • Marko Melolinna

    (Bank of England)

  • Máté Tóth

    (European Central Bank)

Abstract

This paper aims at constructing potential output and output gap measures for the UK which are pinned down by macroeconomic relationships as well as financial indicators. The exercise is based on a parsimonious unobserved components model which is estimated via Bayesian methods where the time-paths of unobserved variables are extracted with the Kalman filter. The resulting measures track current narratives on macroeconomic cycles and trends in the UK reasonably well. The inclusion of summary indicators of financial conditions leads to a more optimistic view on the path of UK potential output after the crisis and adds value to the model via improving its real-time performance. The models augmented with financial conditions have some real-time wage inflation forecasting ability over the monetary policy-relevant 2- to 3-year horizon during the last 15 years. Finally, we also introduce a new approach to construct financial conditions indices, with emphasis on their real-time performance and ability to track the evolution of macro-financial imbalances. Our results can be relevant from both monetary and macro-prudential policy perspectives.

Suggested Citation

  • Marko Melolinna & Máté Tóth, 2019. "Output gaps, inflation and financial cycles in the UK," Empirical Economics, Springer, vol. 56(3), pages 1039-1070, March.
    • Handle: RePEc:spr:empeco:v:56:y:2019:i:3:d:10.1007_s00181-018-1498-4
    DOI: 10.1007/s00181-018-1498-4
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    Citations

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    Cited by:

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    2. Duarte, Cláudia & Maria, José R. & Sazedj, Sharmin, 2020. "Trends and cycles under changing economic conditions," Economic Modelling, Elsevier, vol. 92(C), pages 126-146.
    3. Constantinescu, Mihnea & Nguyen, Anh Dinh Minh, 2021. "A century of gaps: Untangling business cycles from secular trends," Economic Modelling, Elsevier, vol. 100(C).
    4. Lenarčič, Črt, 2021. "Estimating business and financial cycles in Slovenia," MPRA Paper 109977, University Library of Munich, Germany.
    5. Júlio, Paulo & Maria, José R., 2024. "Trends and cycles during the COVID-19 pandemic period," Economic Modelling, Elsevier, vol. 139(C).
    6. Gabor Katay & Lisa Kerdelhué & Matthieu Lequien, 2020. "Semi-Structural VAR and Unobserved Components Models to Estimate Finance-Neutral Output Gap," JRC Working Papers in Economics and Finance 2020-11, Joint Research Centre, European Commission.
    7. Kai Carstensen & Felix Kießner & Thies Rossian, 2023. "Estimation of the TFP Gap for the Largest Five EMU Countries," CESifo Working Paper Series 10245, CESifo.
    8. Guillochon, Justine & Le Roux, Julien, 2023. "Unobserved components model(s): output gaps and financial cycles," Working Paper Series 2832, European Central Bank.
    9. Koester, Gerrit & Lis, Eliza & Nickel, Christiane & Osbat, Chiara & Smets, Frank, 2021. "Understanding low inflation in the euro area from 2013 to 2019: cyclical and structural drivers," Occasional Paper Series 280, European Central Bank.
    10. Nataliia Ostapenko, 2022. "Do output gap estimates improve inflation forecasts in Slovakia?," Working and Discussion Papers WP 4/2022, Research Department, National Bank of Slovakia.

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    More about this item

    Keywords

    Bayesian estimation; Business cycle; Forecasting; Financial conditions; Real-time data; Unobserved components model;
    All these keywords.

    JEL classification:

    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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