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July 23, 2012

How big is the output gap?

It's fair to say, I think, that the question posed in the title of this blog post is at the heart of any monetary policy debate.

Here's how the discussion went at the June meeting of the Federal Open Market Committee (FOMC):

"Meeting participants again discussed the extent of slack in labor markets. Some participants judged that the unemployment rate was being substantially boosted by structural factors such as mismatches between the skills of unemployed workers and those required for available jobs....One implication of the view that there is relatively little slack is that providing more monetary stimulus would be likely to raise inflation above the Committee's objective. Some other participants acknowledged that structural factors were contributing to unemployment, but said that, in their view, slack remained high and weak aggregate demand was the major reason that the unemployment rate was still elevated. These participants cited a range of evidence to support their judgment....These arguments imply that slack in labor markets remains considerable and therefore that a reduction in the unemployment rate toward its longer-run normal level would not have much effect on inflation."

If you want more specifics about these contrasting views, you might find recent speeches by some FOMC meeting participants helpful. Jeff Lacker, president of the Federal Reserve Bank of Richmond, is pretty clearly in the "relatively little slack" group:

"It's worth noting...that the effects of unemployment insurance benefits together with the effects of labor market inefficiencies could plausibly account for a quite substantial portion of our elevated unemployment rate. The quantitative estimates of labor market mismatch come from independent methods and datasets and, in principle, measure conceptually distinct inefficiencies. We shouldn't necessarily assume these effects are additive, but combining all three together yields a range of 2.9 to 5.9 percentage points, which is sizable relative to the increase in the total unemployment rate of 5-½ percentage points during the recession."

Vice Chairman Janet Yellen is also pretty clearly on the other side of the debate:

"A critical question for monetary policy is the extent to which these numbers reflect a shortfall from full employment versus a rise in structural unemployment. While the magnitude of structural unemployment is uncertain, I read the evidence as suggesting that the bulk of the rise during the recession was cyclical, not structural in nature.

"Consider...the difference between the actual unemployment rate and the Congressional Budget Office (CBO) estimate of the rate consistent with inflation remaining stable over time...[the] index of the difficulty households perceive in finding jobs...[and the] index of firms' ability to fill jobs....All three measures show similar cyclical movements over the past 20 years, and all now stand at very high levels."

The positions outlined above lay bare why estimates of the output gap command such weight in the discussion of monetary policy—both ends of the FOMC's dual mandate of maximum employment and price stability may run through it. If the output gap is large, that is, if the level of gross domestic product (GDP) is running significantly under potential GDP, the economy is obviously not in a position of maximum employment. And if that is the case, the inflation trend is likely to be headed lower and so the price stability mandate may also be in jeopardy.

Where do I come out in this debate? That isn't important since I don't get a vote. But my boss, Dennis Lockhart does, and he laid out his position in a recent speech to the Mississippi Economic Council.

"I think the output gap—the amount of slack in the economy—is neither as sizeable as the high-end estimates, nor is it zero. If there were no slack at all, 8.2 percent unemployment would represent full employment. If this were so, the economy would have undergone profound structural change over the last five years. As I weigh the findings of research by Federal Reserve economists and others, I do not think a compelling case has yet been made that structural adjustment has played a dominant role in slowing growth and progress against unemployment.

"If, on the other hand, slack in the economy were close to the high estimates, we should have seen more and more persistent downward pressure on prices and wages than has, in fact, been the case. Deciding on the extent of the output gap is not straightforward. I believe the truth is in the gray middle."

To emphasize, this "gray middle" isn't a compromise but a weighing of the available evidence. If the GDP gap really is close to zero, the profound structural change that the economy ought to have experienced hasn't found great support in the data. But if this is just a bigger version of gaps of recessions past, then where is the great disinflationary pressure such slack would ordinarily imply?

You may have another view and, again quoting Lockhart's recent speech, "reasonable people can consider the issues...and come to different conclusions. "And if you're having trouble getting a grasp on GDP, potential GDP, and why the measurement of our national potential isn't an easy task, perhaps we can help. We've recently produced an educational video on the issue. It's not a deep treatment of the issue—in fact, just the opposite. It's a jumping-in point for those who are interested in the policy debate but haven't a clue what a GDP gap is. As always, let us know what you think.

Mike Bryan By Mike Bryan, vice president and senior economist in the research department at the Atlanta Fed


July 23, 2012 in GDP | Permalink

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well, the size of the output gap is mostly beside the point: we *never*, never know the size of the output gap. We didn't in 2007. We didn't in 1998, nor did we know it 1976. Pick a year, we didn't know it that year either.

So whether we know the size of the gap or not should not be relevant, since we've never actually known it. Nor do we know the lags or leads with which monetary policy affects the economy (i say leads, because we know planners set expectations so policy acts with a lead).


The name of the game is not to pick a policy target that corresponds to the size of the output gap, an unknown. The name of the game is to pick a policy that we know will have desirable outcomes *regardless* of the size of the output gap.


Another fact we know is that most people learn on the job. Back in the 90s during the IT boom, most people entering IT did had other backgrounds. Employers in the US generally train employees (even if they have a grad degree). When demand for labor is high enough, employers cant be as picky as they are now. There is no such thing as "structural unemployment" only low demand for labor.


Third, we know that the Federal Reserve cannot target import prices without raising unemployment. 80% of the gap between PCE and GDP deflator is correlated with *oil prices.* You know, the housing market was well into recession in 2008, when the fed left rates at 2% in sept 2008, because it was overly focused on an inflation measure highly influenced by oil prices.

When you add all this up: unknown potential output, weak aggregate demand, and inappropriate measures of domestic inflation, it all adds up to failed policy.

A far better policy over the last 5 years would have been simple nominal income targeting. Had the Fed simply targeted a 4.5% growth path and agreed to steer the nominal economy along that path, we would be in far better shape regardless of the size of the output gap. So-called deleveraging would be proceeding as a far more rapid pace.


Posted by: dwb | July 24, 2012 at 08:28 AM

Precisely how would income targeting work? The Fed controls interest rates, not the aggregate money supply. It has tried monetary targeting, interest rate targeting, inflation targeting, and yet we never see the results promised from said policies.

Posted by: Ben Wolf | July 24, 2012 at 02:14 PM

I think the combination of low demand for both consumers and businesses despite the very low interest rate environment, the acceptance of these same low interest rates on the part of investors, and the inability of labor to gain meaningful rises in wages all suggest a considerable amount of slack in the global economy in general, and the U.S. economy in particular. Indeed, if I am correct, if government austerity measures continue, inflation is practically an impossible outcome over the next couple of years. The debt overhang is simply too great.

Posted by: m ellenberger | July 26, 2012 at 06:05 AM

We have little correctable long term slack in my view. Our lower skilled labors now compete at historically unprecedented intensity with lower cost, adequately educated, foreign workers who enjoy the competitive access offered by shipping technology advances. This situation is apt to endure. The ongoing rise of computers and robotics will continue to erode labor needs in factories and even in forestry. The nation should enjoy a temporary bounce-back over several years as housing markets return to some degree of normalcy. But long term, we suffer from having a standard of living that exceeds our capacity to compete.

Posted by: Marvin McConoughey | July 31, 2012 at 01:13 PM

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July 13, 2012

What’s to be done?

It's always hard to please everyone. Sometimes it's hard to please anyone. You probably don't need a lot of convincing on this point, but if you desire one more case study look no further than the past week's commentary on monetary policy, starting with Wonkblog's rather negative performance review (post by Brad Plumer) of the Fed's recent policy decisions:

"Right now, unemployment is falling more slowly than the Fed expected when it issued its forecasts back in April... When the Fed published its forecasts, it expected more jobs reports like April's, which initially showed the economy adding 115,000 jobs new jobs. But that hasn't happened… Which means the Fed's own numbers prove the Fed is failing to meet its dual mandate of keeping unemployment and inflation low. (Inflation is below the central bank's target right now; unemployment is not.)"

Plumer favorably references an earlier item from the Peterson Institute's Joe Gagnon, bearing the damning title "The Fed Shirks Its Duty":

"On June 20, 2012, the Federal Reserve System's Federal Open Market Committee extinguished the last shred of doubt as to whether it intends to achieve its mandated objectives."

Carnegie Mellon's Alan Meltzer similarly wonders "What's Wrong With the Federal Reserve?" But his lament, published earlier this week in the op-ed pages of the Wall Street Journal, doesn't exactly mesh with the Gagnon-Plumer school of thought.

"One of the Fed's big mistakes is excessive attention to the short term, over which it has little influence...

"The problem with the short term is that data reported today are subject to revision, or reflect only transitory changes. The better economic data last winter are one of many examples. Would the reported improvement in the economy persist? We didn't learn the answer until weaker data reported this spring. Is the slowdown persistent or temporary? We can only guess.

"Executing monetary-policy changes in response to transitory data is a mistake...

"Today's economic problems are serious, but the Fed can't do much about them if these problems are not monetary. Very expansive monetary policies did help during the crisis of 2008–09, but they're not what is needed now…"

I don't see a dispute here about the fact in the first half of the year the U.S. economy has grown considerably slower than most people—including those in the Fed—thought it would. As usual, the dispute comes down to how to interpret those facts and what to do about them.

Material differences of opinion about how to interpret the current economic environment was the focal point of a speech given today by Atlanta Fed President Dennis Lockhart, in Jackson, Mississippi. Acknowledging the divergent views represented by the Plumer, Gagnon, and Meltzer views, President Lockhart offers his own:

"The question that the members of the FOMC confront is whether there is more that can be done to address the related challenges of slower GDP growth and tepid job creation. So, to wind up, let me give you my take on the key questions underlying a decision to bring on more monetary stimulus.

"I think the output gap—the amount of slack in the economy—is neither as sizeable as the high-end estimates, nor is it zero. If there were no slack at all, 8.2 percent unemployment would represent full employment. If this were so, the economy would have undergone profound structural change over the last five years. As I weigh the findings of research by Federal Reserve economists and others, I do not think a compelling case has yet been made that structural adjustment has played a dominant role in slowing growth and progress against unemployment.

"If, on the other hand, slack in the economy were close to the high estimates, we should have seen more and more persistent downward pressure on prices and wages than has, in fact, been the case. Deciding on the extent of the output gap is not straightforward. I believe the truth is in the gray middle.

"On the risk associated with the balance sheet: in my judgment, some further use of the balance sheet to promote continued recovery and/or financial stability brings with it manageable risks. I think reversal of the cumulative balance sheet scale and maturity structure can be accomplished in an orderly manner. But the step of additional balance sheet expansion should be undertaken very judiciously. Such a step would take us further into uncharted territory.

"On the likely effectiveness of further monetary stimulus—a policy that would necessarily be brought to bear at least in part through credit channels—I think we should have modest expectations about what further action can accomplish. I do not think this means monetary policy is impotent or has reached its limit. But I don't see more quantitative easing or similar policy action as a miracle cure, especially absent fixes in policy areas outside the central bank's purview."

And to the dimming forecasts:

"So, as one policymaker, here's my situation: my support for the current stance of policy rests on a forecast that sees a step-up of output and employment growth by year-end and into 2013. If the economy continues on the track indicated by the most recent incoming data and information, that forecast will become untenable, as will the policy premises underlying it."

Plumer and Gagnon argue we are already at that point. Meltzer believes otherwise. Lockhart is weighing both possibilities. That approach pleases neither camp, but it's the right thing to do.

David AltigBy Dave Altig, executive vice president and research director at the Atlanta Fed

July 13, 2012 in Federal Reserve and Monetary Policy, Forecasts, Monetary Policy | Permalink

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We never know the "natural rate" of employment or unemployment, or the speed limit of the economy, until we find it. It's an unknown and always will be. We never know how the economy is doing, except with a lag. Back on the 70s we overestimated it, now we are underestimating it (and please don't tell me about structural unemployment, construction is starting to pick up in AZ and NV as the foreclosure pipeline drains, just as one would expect- there is even demand for drywall).

The key fact about the recovery is that its not a new phenomenon that the Fed missed forecasts. The Fed forecasts have consistently underestimated the strength of the recovery, an indirect effect of underestimating how long it would take to work out all those mortgages (200k/month foreclosures and 700+ days homes are in foreclosure).

The Fed has also consistently overestimated inflation.

Underestimating inflation and underestimating the strength of the recovery (in a biased way, both of which mean insufficient aggregate demand) means the Fed has done a very poor job correcting for bias.

The even sadder news is that there is a policy that corrects for uncertain potential output in the face of the kinds of nominal rigidities facing the economy, ngdp level targeting.

And the worse news is that if the magically Fed corrects its bias and/or adopts better policy in a Romney administration, it will damage its credibility and independence forever because the perception will be that the FOMC was willfully blind to hurt Obama, especially when it knew of policies that worked in the past but did not use them. I am not saying i agree, but perception is reality in DC and there is a strong case the Fed will be seen as a GOP/banker tool having failed to catch the housing market, JP Morgan, and failure to even conduct monetary policy appropriately. Sad to see the Fed shoot itself in the head.


Posted by: dwb | July 15, 2012 at 10:07 AM

There's an old saying in the newspaper business that goes something like "Just because everybody hates what you're doing doesn't make you right." There is no better example of that than this post.

A huge problem in public discourse these days is the "false balance" epidemic that is sweeping through our policy debates. One side steps up and offers facts, the other polemic, yet each are presented with the same deference. For example, Mr. Meltzer states that:

"Evidence is growing that many think higher inflation is in our future." If you look at these expectations in places such as, say, the Atlanta Fed inflation dashboard, you see no such thing. Instead what you have is someone who is so invested in their paleolithic monetarist framework that they simply have checked out of reality altogether.

The notion of policymakers agonizing over difficult choices amidst the well-thought-out differences of opinion among experts is appealing, but has no application to the current situation. There are only timid and coopted unelected (and unconfirmed) regional Fed bank presidents who unnecessarily prolong the agony of millions in the interests of the top tier of financiers.

Posted by: Rich888 | July 15, 2012 at 08:29 PM

The Fed needs to reassess those policies fixes outside their purview for they are not. It's policies are leading directly to tax cut extensions and larger budget deficits. At this point they have responsibility for both inflation and deficits.

Posted by: Lord | July 16, 2012 at 12:08 PM

I think the Fed is out of bullets. Only responsible fiscal policy can save the short term, and good luck with that.

Posted by: Jeff Carter | July 16, 2012 at 05:48 PM

Dave,
You only get to play the "elder statesman" card if you get things right. The Fed has been wrong over and over since the crisis started....and always in the same direction. Inflation is always below target and unemployment is always over.

Not to be mean, but wake up and smell the recession!

Posted by: robbl | July 17, 2012 at 12:17 PM

I think the Fed is out of principal points. Only accountable financial plan can save the temporary, and best of fortune with that.

Posted by: seo florida | July 18, 2012 at 02:33 PM

your first chart, the prices are actually always increasing every month....i think thats interesting given the question of this blog post...

Its so funny to read questions from Fed people regarding prices and where they are headed, you print the money and control interest rates, how do you not know over the long term. You guys should give me a job there, I could do the thinking for 5 of you.

Good luck with your balance sheet guys. When your bank notes collapse, people like yourself will be responsible.

Posted by: youguyshavedegree's?? | July 19, 2012 at 03:23 PM

Unemployment in a certain country contributes a great help to the growth of its economy. Just like the U.S. economy which has grown slower because of the increase of unemployment in the country. More jobs must be opened to make a country more financially stable and the continuous growth of the economy will be easily met.

Posted by: Jonathan Mansho | August 11, 2012 at 12:16 PM

There are many encouraging signs and indicators tbat are improving.....Stay the course
.be patient
.....Good Work Bernanke!

Posted by: Anne | September 04, 2012 at 04:02 PM

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