Estimating the neutral real interest rate in an emerging market economy

Abstract

This study estimates the neutral real interest rate and output gap jointly under two different multivariate unobserved components models. In the analyses, Kalman filter is applied to a small-scale macroeconomic model of the Turkish economy to estimate the unobserved variables for the period 1989 to 2005. In addition, two alternative specifications for neutral real interest rate are exploited in the analyses. The first model uses a simple random walk model for the neutral rate, whereas the second one employs more structural specification, which specifically links the neutral rate with the trend growth rate and the long-term course of the risk premium by adapting the model proposed by Laubach and Williams (2003) to allow for small open economy consideration. Model evaluations clearly indicate the use of more structural specification against random walk specification. Results point out that the variation in the long-term course of the risk premium could be an important determinant of the neutral real interest rate in Turkey. Though there is relatively high uncertainty surrounding the neutral rate estimates to use them directly in the policy-making process, estimates appear to be very useful for ex post monetary policy evaluations.

Acknowledgements

The views expressed in this article are solely those of the authors. We would like to thank Kenneth N. Kuttner, who kindly provided us the GAUSS code. We also would like to express our sincere appreciation to Ali Hakan Kara, Özge Akıncı, Çağrı Sarıkaya, Ümit Özlale, Özlem İlk and Hayri Körezlioğlu for useful contributions.

Notes

¹Giammarioli and Valla (2004) present a comprehensive discussion of the alternative estimation methods of the neutral real interest rate.

² Recent examples for the application of this method include Clark and Kozicki (2004) for the US, Mesonnier and Renne (2004) and Garnier and Wilhelmsen (2005) for euro area, Wintr et al. (2005) for euro area and Luxembourg.

³ Following the Kuttner's (1994) specification, Öğünç and Ece (2004) estimated the output gap for the Turkish economy. Afterwards, Kara et al. (2007) employed extended Kalman filter to estimate the output gap, in which the parameters of the system are allowed to be time varying.

⁴ It means that, in the absence of shocks, output growth would converge to the within 1% of the steady-state rate in just about 5 years.

⁵ We used the reciprocal of quarterly average of borrowing maturity (months) in treasury auctions as a risk premium measure. Trend component of the risk premium measure is obtained from the HP filter. Two quarters of forecasted values are exploited, so that the influence of the end-sample uncertainty is reduced.

⁶ For the details regarding the Kalman filter, readers are requested to refer to Anderson and Moore (1979) and Harvey (1990).

⁷ The estimated figures are two-sided (smoothed) estimates unless otherwise stated.

⁸ The first period is the 1994 currency crisis. After that, economy recovers and the period roughly between 1997 and 1998:04 emerges as an expansionary period. Then, with two major shocks, namely the Russian crisis at 1998:03 and the earthquake at 1999:03, Turkish economy encounters second recession phase. And the last one is the 2001 economic crisis. For a detailed historical evaluation of the output gap estimates, see Kara et al. (2007).

⁹ One should note that in this article our comments on the monetary policy stance just comprise the interest rate policy. A more comprehensive assessment should be made over the real monetary condition index.

¹⁰ The halt in the decrease of the real interest rate in 2003 is mainly resulting from concerns regarding Iraqi war in the first quarter of 2003.

¹¹ On the other hand, with the implementation of the inflation-targeting regime, it is believed that the percentage of the agents forming their expectations and thereby determining their pricing policy in a forward-looking manner has been increasing in line with the credibility of the implemented policies.