Output Gaps, Inflation and Financial Cycles in the United Kingdom

Abstract

This paper aims at constructing potential output and output gap measures for the United Kingdom 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 United Kingdom 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 inflation forecasting ability over the monetary policy relevant two to three-year horizon during the last fifteen years, although this ability diminishes in a real-time setting. Finally, we also introduce a new approach to constructing 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.