How Informative Are Real Time Output Gap Estimates in Europe?

Abstract

We study the properties of the IMF-WEO estimates of real-time output gaps for countries in the euro area as well as the determinants of their revisions over 1994-2017. The analysis shows that staff typically saw economies as operating below their potential. In real time, output gaps tend to have large and negative averages that are largely revised away in later vintages. Most of the mis-measurement in real time can be explained by the difficulty in predicting recessions and by overestimation of the economy’s potential capacity. We also find, in line with earlier literature, that real-time output gaps are not useful for predicting inflation. In addition, countries where slack (and potential growth) is overestimated to a larger extent primary fiscal balances tend to be lower and public debt ratios are higher and increase faster than projected. Previous research suggests that national authorities’ real-time output gaps suffer from a similar bias. To the extent these estimates play a role in calibrating fiscal policy, over-optimism about long-term growth could contribute to excessive deficits and debt buildup.

What Do We Talk About When We Talk About Output Gaps?

“…Yet another line of work notes the asymmetric history of output gap estimates. Looking at the record for European countries, Kangur et al (2019) find that there is a negative skew in estimates, meaning that countries are more often thought to be operating below potential than above it 11 . A symmetric business cycle would presumably not produce these results although some theories, including the plucking model, are consistent with such behavior 12 .…”

“…Kangur et al (2019) provide a recent overview of the IMF-estimated output gaps for Europe.18 IEO (2014) p. 28.19 As in other papers, we make the distinction between real time estimates and final or revised estimates. The former implies an estimate at time t of the output gap at time t whereas the latter is the time t+n estimate of the output gap at time t.©International Monetary Fund.…”

Can key interest rates decrease output gaps?

“…Another unresolved issue is the study of the asymmetric effects of positive and negative GDP gaps. Monetary policy may differ during periods of economic boom and bust (e.g., Kangur, Kirabaeva, Natal, & Voigts, 2019). However, additional analysis is needed to determine the level of these differences.…”

Measuring Output Gap

“…In their second fiscal risks report, the Office for Budget Responsibility (2019) highlights output gap mismeasurement as a fiscal risk. 5 For the IMF, Kangur et al (2019) show that real-time output gap estimates exhibit large and negative biases ( Figure 1) and are not useful to predict inflation. We contribute to the literature by comparing properties of output gap estimates obtained using different methods, including a two-variable Blanchard and Quah (1989) SVAR and a range of filtering techniques.…”