Future real GDP: real interest rate and inflation matter

This study demonstrates that the real interest rate and headline inflation significantly lead real output. Specifically, the level of the real long-term interest rate positively influences future output, while changes in this rate and the level of headline HICP inflation have a negative impact. This is shown for euro area real GDP growth two to eight quarters ahead, conditional on the leading content of six established output predictors that capture monetary policy transmission channels. The findings are robust when considering ex ante proxies for inflation expectations – autoregressive inflation forecasts and the Survey of Professional Forecasters’ inflation expectations – instead of relying on ex post actual GDP deflator inflation. This robustness remains when using instrumental variables estimation, accounting for nonlinearities, or employing a machine learning tool. Out-of-sample forecast performance underscores the advantage of averaging forecasts from the eight individual predictors, especially for longer ahead forecast horizons. A policy implication is that output forecasters should closely monitor inflation.