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 40 model subscribers, mainly in the policy community. Most countries in the OECD (1) are modelled separately, and there are also separate models of China, India, Russia, Hong Kong, Taiwan, Brazil, South Africa, Latvia, Lithuania, 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 http://nimodel.niesr.

There are a number of key assumptions underlying our current forecast. The interest rates and exchange rate assumptions are shown in tables A1-A2. Our short-term interest rate assumptions are generally based on current financial market expectations, as implied by the rates of return on treasury bills of different maturities. Long-term interest rate assumptions are consistent with forward estimates of short-term interest rates, allowing for a country-specific term premium in the Euro Area.

In this context, we note that after reversing its main policy rate to its record level of 1 per cent and engaging in two rounds of long-term refinancing operations, the ECB has recently adopted a 'wait and see' approach, as inflation is expected to remain above 2 per cent in 2012 and economic growth has stabilised at low levels. Meanwhile, the Bank of England maintained its interest rate at its record low 0.5 per cent, whilst expanding its programme of asset purchase by a further 50 billion [pounds sterling] in February. Total asset purchase reaches a total of 325 billion [pounds sterling] to date, aiming at averting a deflationary spiral by using central bank reserves to purchase government bonds. The Bank of Japan also maintained its current rate unchanged in the short term in order to support economic growth after the twin disasters of March 2011. The Federal Reserve continues to stress that interest rates in the US will remain low for an extended period, while Canada maintained the target for the overnight rate at 1 per cent, anticipating sluggish global growth and the risk that Europe's debt crisis could linger on.


Similarly, after widespread interest rate hikes in the emerging economies, official rates have been kept on hold in recent months as the global inflationary pressure coming from high food and oil prices appears to ease. However, in Brazil, the central bank has just announced its sixth policy rate cut since August 2011, which now stands at 9 per cent as a response to lower growth expectations this year.

Figure A1 illustrates our projections for real long-term interest rates in the US, Euro Area, Japan and Canada. Long real rates followed nominal rates in a sharp drop since the second quarter of 2011 in the Euro Area, Canada, and Japan, whilst they have improved in recent months in the US. The monetary stance is expected to remain expansionary until 2013-14, when real interest rates in North America are expected to stabilise close to historical levels. A somewhat higher level in the Euro Area, where the long real rate is forecast to average 1 1/2 per cent this year, reflects the risk premium on sovereign debt in Greece, Ireland, Portugal, Spain and Italy. We see real interest rates in Japan stabilising around a level rather below international rates of return.


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. …

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