We might be hearing a little less talk from the Federal Reserve about how much “slack” there is in the economy (Fedspeak for the “output gap”, or the difference between real and potential growth) after a new report by Commerzbank as detailed in this Bloomberg story.
The Federal Reserve, Bank of England and European Central Bank have started using the level of spare capacity in their economies as a way to foretell when they will start reversing easy monetary policies. The more capacity, the bigger the output gap between actual and potential economic growth and the longer officials can keep interest rates low because price pressures will be sluggish.
“While this sounds plausible, past experience suggests that central banks tend to hike rates too slowly, with corresponding risks for price inflation,” Christoph Balz and Bernd Weidensteiner, economists at Commerzbank AG in Frankfurt, said in a March 21 report.
The problem is that output gaps are hard to estimate and better done in hindsight. To demonstrate that, the Commerzbank economists looked at what the Fed would have estimated for the output gap in the early 1970s, given the data they had available from the prior three decades.
The initial impression was of an output gap of minus 1 percent for 1974, which would have encouraged the U.S. central bank to be “moderately expansionary,” said the report.
In reality, the economy was later shown to have been slightly over-stretched in 1974. Repeating the exercise for 1983, the output gap the Fed would have calculated at the time was minus 1 percent, versus the minus 4 percent it proved to be.
“A more restrictive policy would have been appropriate in 1974, but in 1983 a more expansionary policy was required,” said Commerzbank. “This demonstrates the uncertainty when monetary policy conclusions are drawn from the current data set.”
With the Fed’s new lines of communication aimed at damping expectations of rate hikes, the risk is the Fed “will again probably raise rates too late and too cautiously,” said the economists. This time the “greater danger” may be that loose monetary policy fans inflation in asset prices.
This idea that, it doesn’t matter how economic growth arrived at a particular level (e.g., in 2007 after the biggest credit bubble since the 1930s) and that you should somehow gauge future economic growth against past growth (regardless of how artificial it was) – this is one one of the stupidest things that economists have ever come up with.