Academic journal article National Institute Economic Review

Appendix A: Summary of Key Forecast Assumptions

Academic journal article National Institute Economic Review

Appendix A: Summary of Key Forecast Assumptions

Article excerpt

The forecasts for the world and the UK economy reported in this Review are produced using NIESR's model, NiGEM. The NiGEM model has been in use at the National Institute for forecasting and policy analysis since 1987, and is also used by a group of about 50 model subscribers, mainly in the policy community. Most countries in the OECD are modelled separately, and there are also separate models of China, India, Russia, Hong Kong, Taiwan, Brazil, South Africa, Estonia, Latvia, Lithuania, Slovenia, Romania and Bulgaria. The rest of the world is modelled through regional blocks so that the model is global in scope. All models contain the determinants of domestic demand, export and import volumes, prices, current accounts and net assets. Output is tied down in the long run by factor inputs and technical progress interacting through production functions, but is driven by demand in the short to medium term. Economies are linked through trade, competitiveness and financial markets and are fully simultaneous. Further details on the NiGEM model are available on


There are a number of key assumptions underlying our current forecast. The interest rates and exchange rate assumptions are shown in tables Al-A2. Our short-term interest rate assumptions are generally based on current financial market expectations, as implied by the rates of return on Treasury yields of different maturities. Longterm interest rate assumptions are consistent with forward estimates of short-term interest rates, allowing for a country-specific term premium in the Euro Area. We have assumed short-term interest rates begin to rise in the second quarter of 2011 in the US and UK, and in the third quarter of 2011 in the Euro Area. In Japan, short-term interest rates are expected to remain below 1/4 per cent until the end of 2012.

The Bank of Canada raised interest rates by 25 basis points in June 2010 and by a further 25 basis points in the Bank's July announcement. The second rise was made after our forecast figures were completed and is not incorporated into our underlying assumptions, which include a rise of 50 basis points in the Canadian target rate in the fourth quarter of 2010. The Riksbank and the Reserve Bank of New Zealand have also raised interest rates by 25 basis points at their most recent monetary policy meetings. The Reserve Bank of Australia has increased interest rates by 150 basis points while Norges Bank has increased rates by 75 basis points since October 2009, as economic recovery has come earlier in Australia and Norway, and rising commodity prices have pushed up inflation.

Figure A1 illustrates our projections for real long-term interest rates in the US, Euro Area, Japan and Canada. Long real rates have risen from the low points reached in 2009, but the monetary stance will remain expansionary until 2014-15, when real interest rates in North America and Europe are expected to stabilise close to historical levels. We see real interest rates in Japan rising above recent historical lows, but stabilising around a level rather below international rates of return. Nominal interest rates will continue to rise after this point to reach 4.8 per cent in the longer term.

Long real rates are illustrative measures of the state of the economy, but do not reflect the actual borrowing costs faced by firms, which pay a premium above the risk-free rates to reflect the risk of default. Figure A2 illustrates the spread between corporate bond yields and 10-year government bond yields in the US, UK and Euro Area. Following the collapse of Lehman Brothers in September 2008, corporate spreads jumped to their highest level since the Great Depression. After falling to recent lows in April 2010, spreads have started to edge up slightly, which may point to heightened risk of a second financial crisis. We expect corporate bond spreads to maintain a positive margin over the low levels seen in 2000-2006. …

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