When the topic of central banks and the outlook for interest rates comes up, economists often turn to the so-called “star” variables to help with their predictions.

What do we mean by star variables? Why they are important to central bankers, and how do they influence interest-rate decisions?

The star variables relate to key concepts in economic models used by central bankers to help them understand how the economy works.

Star variables are named so simply because they are usually labelled with an asterisk to distinguish them from other variables in economic modelling.

Central bankers don’t normally think about the star variables in isolation. Instead, these variables are better thought of as a “constellation” linking economic growth, the labour market and interest rates together with inflation outcomes.

1. Potential output or y*: This is the economy’s maximum sustainable output that can be produced when all resources are fully employed. It is sometimes referred to as the economy’s speed limit. If economic growth is faster than potential, it can put upward pressure on inflation because demand for goods and services is outstripping supply.

The reverse is also true: if........

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