Working Paper no. 200
By Jens Larsen, Ben May and James Talbot
Any monetary policy maker using a short-term nominal interest rate as the primary policy tool will have an interest in understanding developments in ex-ante real interest rates. In this paper, several methods for calculating real interest rates for the United Kingdom are explored. These include: yields on index-linked bonds; yields on nominal bonds minus an appropriate measure of inflation expectations; and a ‘consumption-based’ measure – derived from manipulating the first-order condition of a standard household intertemporal optimisation problem. It is found that the basic (power utility) version of the consumption-based model suffers from the standard problems outlined in the literature, so the basic framework is augmented to allow for (external) habit formation in consumption, and a general k-period real interest rate is derived. Interestingly, although the different approaches outlined above can sometimes yield very different estimates of real interest rates, all the measures move more closely together during the post-1992 inflation-targeting period than before. Before 1992, uncertainty about the monetary regime, coupled with persistent expectational errors, may have made it more difficult for agents to forecast real interest rates and inflation.