A Big Challenge for the Fed

David Altig recently recently considered the question of how fast the U.S. economy could recover from the recession. He noted that in order to answer this question one would need to know how much spare capacity there is in the U.S. economy. A lot of excess capacity means there are underutilized resources that can easily be employed without straining the economy--a rapid recovery is possible. However, if there is little or no spare capacity then the opposite is true. The standard measure of excess capacity in macroeconomics is the output gap: the difference between actual and potential GDP. A positive output gap means the economy is growing too fast; a negative value indicates there is excess capacity.

So what is the current output gap? As David Altig notes, no one knows for sure and there is wide variation among the current estimates:

To wit, there is substantial variation in output gap estimates across the different methods, and I do mean substantial: The gap estimates for the second quarter of 2009 range from –0.5 to nearly –11 percent depending on which method is used. In other words, some methods imply the gap is very large, others say the gap is rather small.

Now this output gap uncertainty presents problems not only for forecasting how fast the U.S. economy will recover, but also for the Fed's exit strategy. For the Fed to correctly time its exit strategy it needs to know the output gap. Otherwise, it could risk repeating the 1970s inflation debacle. This point was articulated by Edward Chancellor recently in the Financial Times:

[T]he Fed will likely remain passive until the economy is running near full capacity, or what economists call the “output gap” has narrowed. This sounds sensible. After all, inflation comes about when too much money chases too few goods and services, causing the economy to overheat.The trouble is that the track record of economists measuring the output gap in real time is rather patchy, to say the least.

Research by Athanasios Orphanides, a former Fed staffer and the current head of the Cypriot central bank, reveals the limitations of output gap analysis. This gap is said to exist when current output is below its trend level. Unfortunately, economists can’t agree on which statistical techniques best measure this trend. Different methods produce widely differing estimates of the output gap; they even differ as to whether the sign is positive or negative. For instance, at the turn of the century the European Central Bank reckoned the output gap for the eurozone to be negative (ie potentially inflationary). In later years this figure was revised as positive. Subsequent revisions to the output gap have been as large as the original estimate.

Historically, the greatest errors in the measurement of the output gap have occurred at times when the economy entered a period of structural change. In late 1973, for example, businesses were forced to adapt to a sudden threefold rise in the price of oil. During the recession which followed, contemporary calculations suggested the US economy was operating at around 10 per cent below capacity. Only later did it become clear that the energy crisis constituted a “supply shock”, rendering much embedded capacity redundant and shifting the economy to a lower trend growth rate.

At the time, the Federal Reserve failed to recognise the impact of this supply shock. In response to what was then believed to be a mere cyclical downturn, interest rates were kept low. Only subsequently was it revealed that the economy was operating at near full capacity despite large unemployment and that monetary policy was too loose. By then it was too late to prevent the great stagflation.

I would note that one of the assumptions in the above discussions is that the Fed aims to stabilize inflation. Given this objective, getting the estimate of the output gap right correct is a big deal for the Fed. Of course, if the Fed were to move to a nominal income targeting rule then the output gap issue would be moot. Just another reason to rethink nominal income targeting.

Update: Arnold Kling has a few things to say about the output gap.