Monetary Policy When The Spyglass Is Smudged: A Look At Gauging Economic Slack

by Early Elias, Helen Irvin, and Oscar Jorda – FRBSF Economic Letter, Federal Reserve Bank of San Francisco

An accurate measure of economic slack is key to properly calibrating monetary policy. Two traditional gauges of slack have become harder to interpret since the Great Recession: the gap between output and its potential level, and the deviation of the unemployment rate from its natural rate. As a consequence, conventional policy rules based on these measures of slack generate wide-ranging policy rate recommendations. This variability highlights one of the challenges policymakers currently face.

It would be a mistake to characterize the Great Recession as simply a run-of-the-mill economic downturn, only larger in magnitude. In the post-World War II era the United States experienced both deep recessions and episodes of financial turmoil, but not since the Great Depression had the U.S. economy suffered both simultaneously. The degree of economic dislocation has been considerable, greatly altering the long-term structure of the economy and the outlook.

Economists are still grappling with this new economic order and how to refine their thinking. Not surprisingly, implementing policy in such an uncertain economic environment has been specially challenging. This Economic Letter examines how this new environment has made traditional measures of economic performance harder to interpret. The tool we use to communicate these policy challenges is the well-known Taylor rule.

This is the first in a two-part series. The second (Bosler, Daly, and Nechio 2014, forthcoming December 1) details mixed signals from the labor market.

Large revisions to potential output

The deviation of real GDP from its potential level has long been regarded as a standard measure of economic slack. When the economy grows faster than its potential, the effects are widespread: Overtime hours increase for workers, capital utilization rates go up for businesses, and inflation pressures mount for consumers. Not surprisingly, the difference between real GDP and its potential level, known as the output gap, is closely scrutinized by policymakers. Although potential GDP is not directly observable, the Congressional Budget Office (CBO) regularly publishes an estimate of its value.

Data on both real GDP and potential GDP go through a number of revisions. Data on real GDP come from the National Income and Product Accounts (NIPA) published by the Bureau of Economic Analysis. The NIPA relies on a wide variety of data that differ in quality, coverage, and availability. Initial GDP estimates rely mostly on smaller-scale surveys, which are available reasonably quickly. Over time, survey data are replaced with large-scale census data, which are more exhaustive but take longer to collect.

Figure 1
Revisions to potential GDP

Sources: BEA and CBO, chained 2009 dollars.

By contrast, potential GDP estimates are revised less frequently. Moreover, past revisions have usually been small so that even initial estimates about future values have been reliable. Potential GDP had moved slowly enough that the CBO releases yearly updates together with 10-year projections. However, the Great Recession eradicated this stability and has vividly demonstrated how quickly estimates of potential GDP can change in times of economic tumult. Between 2007 and 2014, the CBO revised its projection of real potential GDP for the first quarter of 2014 downward by almost 8%. Figure 1 depicts the CBO’s 10-year projections of potential GDP from 2007, 2010, and 2014 alongside the path of real GDP for context.