The incredible shrinking output gap

Zach Pandl, Senior Portfolio Manager and Interest Rate Specialist | November 13, 2012

When Federal Reserve (Fed) officials say they are working to support the recovery, they are not focused on economic growth per se. Rather, the goal of monetary policy should be thought of as closing “gaps”:

  • Reducing the gap between the unemployment rate and its structural rate (the “unemployment gap”), or
  • Reducing the gap between GDP and the economy’s productive potential (the “output gap”).

Growth and gaps are of course closely related: gaps close when growth is above its normal or potential rate, and gaps widen when growth falls below its potential rate. Growth matters, but only relative to potential growth.

This relationship more or less explains Fed officials’ frustration with the recovery to date. Since the economy bottomed, GDP growth has averaged only 2.2%. However, according to surveys taken at every other Federal Open Market Committee (FOMC) meeting, Fed officials think the economy’s potential growth rate is between 2.2% and 3%. Therefore, if the recovery were to continue at its subdued pace, policymakers believe that growth would not exceed its potential and they would not make progress reducing the unemployment and output gaps.

The problem with a gaps-based approach to policy is that potential growth and the output gap are just theoretical variables—they are not directly observable in the economy. As a result, policymakers do not know in real time whether growth is above or below potential, and/or whether the output gap is shrinking or expanding. We agree that concepts like the output gap are important for understanding the state of the economy. But we prefer a simple and pragmatic approach to get around the measurement problem: we search for indicators that should be correlated with the theoretical output gap and track how they are changing over time. Interestingly, despite historically low GDP growth, virtually all of our observable proxies suggest the output gap is steadily shrinking.

We track seven economic indicators which should be correlated with the true output gap: the unemployment rate; a measure of the employment-to-population ratio; the capacity utilization rate; the net percent of households that see better than normal business conditions; the net percent of households that see jobs as plentiful rather than hard to get; the share of firms that say finding high-quality labor is their most important problem; and the share of firms that say poor sales is their most important problem.

For each indicator except the employment-to-population ratio we simply calculate a normalized score (we subtract the series’ historical mean and divide by its standard deviation). Our measure of the employment-to-population ratio is the residual from a regression of the employment-to-population ratio for persons ages 25 to 54 on a constant and the female share of the workforce. This measure helps account for structural changes in the labor market over time. Normalized scores for these seven indicators are shown in the chart below.

We would make a few observations about these data:

  • First, by and large the output gap proxies are significantly less negative than they were in 2009. The capacity utilization measure has narrowed rapidly, and the others at a gradual pace
  • Second, the shrinking unemployment gap does not look like an outlier. Many analysts and some Fed officials have argued that the decline in the unemployment rate does not signal reduced economic slack because it reflects falling labor force participation rather than strong job growth. But it is difficult to apply this argument to our other measures, four of which are based on surveys that should be less sensitive to data peculiarities.
  • Third, the employment-to-population ratio shows much less improvement than the six other indicators. This probably contains an important message about underemployment and cyclical weakness in labor force participation. However, we think it would be incorrect to focus on the employment-to-population ratio alone, not least because we know it can be affected by secular trends. The truth is likely somewhere in the middle: a smaller narrowing of the output gap than implied by capacity utilization, but a larger narrowing than implied by the employment-to-population ratio.

We can go one step further and use these indicators to estimate an implied output gap and implied potential GDP growth. Based on the common component of our proxy variables, we estimate that the output gap today is around 4.5%.* This compares to an output gap of 7.5% at the worst point of the recession, and a current output gap estimated by the Congressional Budget Office (CBO) of 5.8%. For potential GDP growth, we compare changes in all of the proxy indicators to actual GDP growth. We estimate that potential GDP growth has fallen, at least temporarily, to about 1.75%.** This is down from about 2.5% prior to the recession.

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*For Fed policy, low potential GDP growth, if sustained, would mean that “gaps” could close faster than expected. The output gap and unemployment gap shrink when GDP growth is above its potential. Lower potential growth implies a lower hurdle rate, and a quicker decline in spare capacity for any given rate of overall economic growth.

**First principal component regressed on CBO estimate of output gap. State space model of changes in gap variables on GDP growth. Equations estimated with time-varying intercept; potential GDP growth equals intercept divided by slope coefficient times negative one.