Olivier Coibion, Yuriy Gorodnichenko, and Mauricio Ulate at the CBPP:
The most recent releases of Gross Domestic Product (GDP) imply that the current level of U.S. output is almost equal to the Congressional Budget Office’s (CBO’s) estimate of the “potential level of GDP,” a measure of how much the U.S. economy could produce if its resources were fully and efficiently utilized. The World Bank further estimates that this closing of the output gap has occurred not just in the U.S. but across most advanced economies (World Bank 2018). Ten years after the onset of the Great Recession, according to this view, the economy has finally returned to its potential level and economic policy instruments should be gradually returned to normal levels, a process the Federal Reserve is now implementing.
In this brief, based on our earlier research, we challenge this conclusion. According to our analysis, CBO’s and other similar estimates of potential output are too pessimistic, and as such, they encourage policymakers, such as those at the Federal Reserve, to accept lower levels of potential than those which could be achieved. This pessimistic view and associated policies could be extremely costly to U.S. households.
Our findings include:
In deriving potential GDP, current methods used by key agencies tend to under-respond to the shocks they should respond to and over-respond to the shocks that they should not respond to. Most recently, this has led to some frequently used estimates of potential GDP that are as much as $1.2 trillion, or nearly $10,000 per household, below our preferred estimate. Methods that do not feature the under-/over-responsiveness problem we document imply that more active stimulus on the part of the Federal Reserve is warranted to enable actual GDP to finally catch up to potential. The benefits of this policy shift would include significantly greater household incomes and higher employment levels than those engendered by the current policy stance.
Should the Federal Reserve be Raising Rates due to a Closing Output Gap? ...