The Informational Content of Empirical Measures of Real Interest Rate and Output Gaps for the United Kingdom

Bank of England Working Paper No. 224

45 Pages Posted: 4 Jan 2005

See all articles by Jens D.J. Larsen

Jens D.J. Larsen

Wellington Management

Jack McKeown

Bank of England - Monetary Analysis

Date Written: August 2004

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.

Keywords: Kalman filter, natural rate of interest

JEL Classification: C32, E43, E52

Suggested Citation

Larsen, Jens D.J. and McKeown, Jack, The Informational Content of Empirical Measures of Real Interest Rate and Output Gaps for the United Kingdom (August 2004). Bank of England Working Paper No. 224, Available at SSRN: https://ssrn.com/abstract=641261 or http://dx.doi.org/10.2139/ssrn.641261

Jens D.J. Larsen

Wellington Management ( email )

United States

Jack McKeown (Contact Author)

Bank of England - Monetary Analysis ( email )

Threadneedle Street
London EC2R 8AH
United Kingdom

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