Estimating the neutral real interest rate in an emerging market economy

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.