Even as inflation continues to fall , there are calls to raise interest rates soon in order to quell inflationary pressures. I remember reading similar calls for monetary restraint in Japan in 2000-01, when that country was struggling to escape deflation (I sure had a hard time explaining the fears to my boss, and indeed never came up with a good answer). But rather than dismiss these calls, I think it useful to revisit the different measures of the output gap, to see whether those fears of rampant inflation due to disappearing slack make sense. Fortuitously, Michael Kiley has just circulated a new paper reviewing the various concepts of the output gap (see also these previous posts:   ).
What is the output gap? There are many definitions in the economics literature, all of which have a long history. I discuss three alternatives: the deviation of output from its long-run stochastic trend (i.e., the “Beveridge-Nelson cycle”);
the deviation of output from the level consistent with current technologies and
normal utilization of capital and labor input (i.e., the “production-function
approach”); and the deviation of output from “flexible-price” output (i.e., its
“natural rate”). Estimates of each concept are presented from a dynamic-
stochastic-general-equilibrium (DSGE) model of the U.S. economy used at the
Federal Reserve Board. Four points are emphasized: The DSGE model’s es
timate of the Beveridge-Nelson gap is very similar to gaps from policy institutions, but the DSGE model’s estimate of potential growth has a higher
variance and substantially different covariance with GDP growth; the natural
rate concept depends strongly on model assumptions and is not designed to
guide nominal interest rate movements in “Taylor” rules in the same way as
the other measures; the natural rate and production function trends converge to
the Beveridge-Nelson trend; and the DSGE model’s estimate of the Beveridge-
Nelson gap is as closely related to unemployment fluctuations as those from
policy institutions and has more predictive ability for inflation.
The output gaps are shown in three graphs from the paper.
Figure 3 from Kiley (2010).
Figure 4 from Kiley (2010).
Figure 6 from Kiley (2010).
Based upon his analysis, Kiley makes the following four conclusions:
- The EDO model’s estimate of the output gap (according to either a Beveridge-Nelson or production-function approach) is very similar to gaps from the Congressional
Budget Office or the Federal Reserve’s large-scale macro-econometric model (FRB/US) model, but the DSGE model’s estimate of potential growth is considerably more variable; the latter result stems from the significant degree of fluctuation in aggregate technology estimated by the DSGE model, a result consistent with the significant role such fluctuations play in model’s descended from those of the real-business-cycle tradition (from Kydland and Prescott (1982)).
- The flexible-price/natural-rate gaps are highly dependent on modeling assumptions,
and their use in policy applications or forecasting requires a deep understanding
of a specific model’s structure. (This result is closely related to the
critique of DSGE models of Chari, Kehoe, and McGrattan (2009), who highlight
the sensitivity of policy applications of such models to controversial modeling
assumptions). In particular, a natural-rate gap does not provide the same type
of guidance to a “Taylor” rule for nominal interest rates as other concepts of
gaps; indeed, the signals from the Beveridge-Nelson gap provide a better sense
of movements in the “natural rate of interest” than do the signals from the
natural rate of output gap.
- “Equilibrium” or trend expected growth is highly variable in the flex-price/naturalrate
case, implying that a focus on the current level of such gaps can be misleading
in a policy discussion. In contrast, expected trend growth for the Beveridge-
Nelson concept is exogenous and constant; moreover, all other notions of “trend”
converge to the Beveridge-Nelson trend.
- The DSGE model’s estimate of the Beveridge-Nelson gap is as closely related to
unemployment fluctuations as those from policy institutions (e.g., obeys Okun’s
law) and has more predictive ability for inflation (e.g., has a tighter reduced form
Phillips curve relationship).
For me, one important observation is that the output gap for both the production function based approach from EDO and the CBO estimate are of similar magnitude; 6 ppts and 7.5 ppts of GDP at 09Q2. The natural rate output gap is quite different, and this highlights the fact that this gap embodies a very different concept (discussed at length in the paper). I stress this, exactly because I know somebody is going to take some output gap measure and mis-interpret the implications of that gap — especially as concerns of inflation rise.