The new stars in the Bank of England’s Inflation Report Phiroza Katrak

Policy needs to walk, not run, to stand still", said Governor Mark Carney in his opening remarks at the Inflation Report press briefing.

The Bank of England’s validation for raising interest rates this month was encapsulated in the minutes of the MPC’s meeting and in its latest quarterly Inflation Report.  The other noteworthy, but largely unreported, inclusion in the Inflation Report was r* (r-star), the concept of the equilibrium interest rate adjusted for inflation.

This equilibrium real rate is derived from two other “star” components: R* (the trend real rate, i.e. adjusted for inflation) plus s* (shorter-term influences). 






Equilibrium real rate


Trend real rate


shorter-term component

The Bank’s estimates for these components and their direction will have a bearing on the future path of Bank Rate. 

Put simply, R* is the level of interest rates determined when the economy is running at full capacity that will have a neutral effect on inflation and growth.  Estimating this rate isn’t an exact science. The openness of the UK economy also means that the level of R* in the UK will have some correlation to that in other advanced economies. The Bank’s central estimate for this rate is derived from an average of four models run by its staff.

Which brings us to s*, the shorter-term influences – the factors which provide upward momentum to or bear down on the economy. The tightening in financial conditions and the rise in uncertainty would, in normal times, have been short-term “headwinds” as the Bank likes to term them, but which have been taking a considerably long time to unwind since the onset of the financial crisis and over that time s* has depressed rather than contributed positively to the r* arithmetic.  

The Bank hasn’t provided a figure for r*, only that short-term factors have pushed it below R* and that it expects that over the time if uncertainty dissipates r* will rise towards R*.   R* in the UK has fallen by over 2% since 1990.   The Bank’s central estimate for R* is around ½% in 10 years’ time.  So, adding back the Bank’s target inflation of 2% it implies trend nominal rates would be around 2½% in 10 years’ time. 

The Bank will update its estimates in forthcoming Inflation Reports.  Whichever way the ‘stars’ align, it seems interest rates will not so much walk than plod very slowly rates over the next 10 years.