Frankfurt: European Central Bank policymakers are dismissing the “output gap” as an unreliable measure of slack in the economy, but they can’t ignore it entirely for when the time comes to tighten monetary policy again.
Economists say the gap—the difference between the economy’s full capacity and actual production—is hard to estimate. But despite these shortcomings, it remains an important indicator of inflation pressures which the ECB must look at in some form for medium-term projections.
“It is almost certainly at the centre when thinking about inflation over the next one or two years,” said Nick Kounis at Fortis. “In the longer term, things like money supply are more important, but over the horizon relevant for monetary policy, it is a central concept.”
Global recession has caused demand and economic output to plummet in the euro zone, and estimates of the output gap for this year and next are deep in negative territory.
This could mean low ECB interest rates for a long time, as inflation risks are small because firms can expand production easily and are less likely to raise prices.
Euro zone consumer prices dipped 0.2% from a year earlier in August, far from the ECB’s medium-term target of annual inflation at just below 2%.
Monetary policy is ultra-loose, aiming to help the 16-nation bloc to recover. But policymakers are anxious to avoid sowing the seeds of future inflation by failing to tighten promptly when the economy gets back on its feet.
The ECB does not publish its own estimates of the output gap. Policymakers have said it is of no great importance and stress instead their official ways of checking the state of the euro zone economy, including analysing money supply data.
Nevertheless, they suggest that the gap may be smaller than the European Commission, IMF and OECD have estimated, implying that inflation pressures might build up sooner than expected.
The ECB has kept interest rates at a record low of 1.0% since May, and flooded the banking system with funds. Economists in a Reuters poll forecast that rates wouldn’t rise until the fourth quarter next year.
Executive board member Juergen Stark says uncertainty surrounds how large the output gap is but it is likely to be smaller than estimates, which vary between -3 and -6%.
“If it were that large, inflation risks could stay low for a very long time,” he said last month. “But most recent estimates show a smaller output gap ... We have to realise that potential output has gone down because of the deep recession.”
Since then he has kept playing down its importance.
“Under these circumstances, elusive estimates of the scale of economic slack are even less reliable as a guide for monetary policymakers,” he said. “I would in particular like to highlight that the high priority we attach to the monetary analysis offsets any over-dependence on single, potentially flawed indicators and concepts, such as the output gap.”
Useful even if flawed
Trend estimates of potential output—the amount of goods and services an economy can produce in the long-term without creating additional inflation—depend on actual gross domestic product (GDP) data, which are produced only with a time lag.
Therefore assessment of the output gap also runs behind real time, making estimates even more difficult in the current unsettled economic situation.
While IMF and OECD estimates are probably based on only a minor loss in potential output, ECB statements imply that it sees potential output having been hit drastically by the crisis.
President Jean-Claude Trichet says the ECB is extremely cautious in basing policy on growth potential estimates. But he added: “I fully accept the consensus of economists that the potential growth of all economies of the industrialised world is probably now significantly lower than the previous estimate.”
Lower potential growth would mean the output gap is not as large, and inflation might return sooner than thought. Reasons for lower potential growth include unemployed workers leaving the labour force altogether. Higher loan risk premia would also lower growth potential, as would a change in economic structure.
But the OECD (Organisation for Economic Cooperation and Development) has stuck to its guns. The thinktank said in a recent paper that the cumulative negative output gap tends to be between two to three times greater during financial crises than in other downturns, and that the period before output recovers to capacity is at least twice as long.
The ECB questioned the output gap further in its September bulletin. “The relationship between the output gap and price developments has been mixed in the past, and, on average, relatively large changes in the output gap are needed to affect euro area inflation,” the ECB said.
“That is one reason why euro area inflation might be expected to remain reasonably resilient despite the sharp deterioration in activity.”
Economists say that the ECB is right to be cautious about overestimating the gap but the difficulty of making projections doesn’t mean it can live without them.
“I don’t really believe that the ECB does not look at the output gap,” Kounis said. “Almost every estimate of inflation is based on some kind of output gap concept.”