The informational content of empirical measures of real interest rate and output gaps for the United Kingdom - BIS Papers No 19, part 19, October 2003

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, we estimate the natural rate of interest and the real interest rate gap the difference between the actual and the “natural” real rate of interest 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, we examine whether empirical measures of the real interest rate 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? We find that the real rate gap has leading indicator properties for both output gap and inflation. Importantly, these properties have varied considerably over time: breaking our sample into four subsamples, we find the leading indicator properties for both the output and real rate gap to be substantially stronger for the subsample that comprises 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 neither gap has leading indicator properties for inflation, as we would expect given an inflation targeting regime.