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February 22, 2013
Nature Abhors an Output Gap
In The Washington Post, Neil Irwin highlights a shortcoming that I know all too well:
Throughout the halting economic recovery that began in 2009, the formal economic projections released by the Congressional Budget Office, White House Council of Economic Advisers, and Federal Reserve have displayed quite a consistent pattern: This year may be one of sluggish growth, they acknowledge. But stronger growth, of perhaps 3.5 percent, is just around the corner, and will arrive next year.
Consider, for example, the Fed's projections in November of 2009. Sure, growth would be slow in 2010, they held. But 2011 growth, they expected, would be 3.4 to 4.5 percent, and 2012 would 3.5 to 4.8 percent growth. The actual levels of growth were 2 percent in 2011 and 1.5 percent in 2012.
What's amazing is that the Fed's newest projections, released in December of 2012, look like they could have been copy and pasted from 2009, just with the years changed: They forecast sluggish growth in 2013, 2.3 to 3 percent, followed by a pickup to 3 to 3.5 percent in 2014 and 3 to 3.7 percent in 2015.
I, for one, am guilty as charged, and feel pretty fortunate that the offense is not a hanging one. In fact I don't think Irwin's indictment is overly harsh, and he is on the right track when he offers up this explanation for the last several years' persistently overly rosy projections:
Economic forecasters tend to look at past experience and extrapolate; in the past, when there has been a recession, the very forces that caused the recession become unwound, sowing the seeds for expansion...
Here is a basic fact about macroeconomic forecasting. The truly powerful driver of forecasts is mean reversion, which is the tendency of models to predict that gross domestic product (GDP) will move toward an average trend over time. This fact holds true whether we are talking about formal statistical analysis or the intuitive judgmental adjustments that all forecasters apply to their formal statistical models.
Forecasters are not completely robotic, of course. Irwin is correct when he says "forecasters tend to look at past experience and extrapolate, but forecasters do leaven past experience with incoming details that alter judgments about what is the mean—the "normal state," if you will—to which the economy will converge. But whatever is that normal state, our models insist that we will converge to it.
Nothing illustrates this property of forecasting reality better than this chart, which supplements the latest economic projections from the Congressional Budget Office:
The potential GDP line in that chart is the level of production that represents the structural path of the economy. Forecasters, no matter where they think that potential GDP line might be, all believe actual GDP will eventually move back to it. "Output gaps"—the shaded area representing the cumulative miss of actual GDP relative to its potential—simply won't last forever. And if that means GDP growth has to accelerate in the future (as it does when GDP today is below its potential)—well, that's just the way it is.
Unfortunately, potential GDP is not so simple to divine. We have to guess (or, more generously, estimate) what it is. That guessing game has been harder than usual over the past several years. Here is the record of the CBO's potential GDP since 2009:
I think this picture is a fairly representative record of how views about the potential level of U.S. GDP has evolved over the past several years. What has not been resolved is the debate over what conclusions should be drawn from persistent overestimates of potential and serial misses to the high side on GDP projections.
Irwin seems to be of two minds. On the one hand he offers very structural-sounding reasons for poor forecasting experience:
... the financial-crisis-induced recession of 2008–2009 was so deep that it had deep-seated effects that go beyond those explained by those traditional relationships. It messed up the workings of the financial system, and banks are still trying to figure out what the new one looks like.
On the other hand, he makes appeals to very traditional explanations tied to deficient spending and insufficient policy stimulus (though even here structural change may be one reason that stimulus has been insufficient):
Breakdowns in the financial system mean that low-interest rate policies from the Fed don't have their usual punch. An overhang of household debt means that consumers hold their wallets more than usual. Federal fiscal stimulus to offset those effects is now long-over...
This much, in any event, is clear: Given any starting point where the level of GDP is below its potential level—that is, given an output gap—forecasts will include a bounce back in GDP growth above its long-run average, at least for a while. That's just the way it works.
If, contrary to conventional wisdom, you believe that the true output gaps are much smaller than suggested in the CBO picture above, you might want to take the under on a bet to whether GDP forecasts will prove too optimistic once again.
By Dave Altig, executive vice president and research director of the Atlanta Fed
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