Estimating Policy-Neutral Interest Rates for Canada Using a Dynamic Stochastic General Equilibrium Framework

In an era where the primary policy instrument is the level of short-term interest rates, comparing the level of such a rate relative to some equilibrium value can be a useful guide for policy and a convenient method to measure the stance of monetary policy. The real interest rate gap, the difference between the real equilibrium rate and the rate set by the central bank, can thus serve as a leading indicator of future inflationary or deflationary pressures in the economy. This paper estimates equilibrium interest rates for Canada using a sticky-price dynamic stochastic general equilibrium (DSGE) model. We follow the methodology of Neiss and Nelson (2003) closely and derive measures of the interest rate gap for Canada. Our results indicate that the interest rate gap can be a useful guide for policy and is a good an indicator of future output and inflation. Moreover, we find that our measures of the interest rate gap perform as well as the yield spread, a typical measure of policy stance which is assumed to contain significant information about future economic activity.