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Output gaps, inflation and financial cycles in the UK

Marko Melolinna () and Máté Tóth ()
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Marko Melolinna: Bank of England
Máté Tóth: European Central Bank

Empirical Economics, 2019, vol. 56, issue 3, 1039-1070

Abstract: 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.

Keywords: Bayesian estimation; Business cycle; Forecasting; Financial conditions; Real-time data; Unobserved components model (search for similar items in EconPapers)
JEL-codes: C11 C32 E31 E32 E52 (search for similar items in EconPapers)
Date: 2019
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