Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Watching the Output Gap
Transcript
- Lucas: Central bankers talk about the output gap all the time — but what does it actually mean? Today I want to look at how the ECB has been using the output gap in its rate decisions over the past couple years, and why it's both useful and controversial. Luna: I know the term — it's the difference between where the economy is and where it could be if all resources were fully used. But measuring it seems like a guessing game. Lucas: It absolutely is a guess. But it's an educated guess that shapes policy. Let me give you a number: back in 2020, the ECB estimated the eurozone output gap at minus 2.3 percent — meaning the economy was operating well below potential. By mid-2024, as inflation surged, they pegged it at plus 0.8 percent. That swing from negative to positive helped justify rate hikes. Luna: Right — if you think the economy is running hot, you want to cool it. But that estimate changed fast. Lucas: Exactly. And here's where it gets interesting. By early 2025, Germany's manufacturing sector was in a prolonged slump, and the ECB's own models started showing the output gap turning negative again — maybe around minus 0.5 percent. That pressured the ECB to start cutting rates even though inflation was still above target. Luna: So they basically used the output gap to override the inflation numbers. Lucas: Not entirely override — but it gave them cover to ease. The thinking goes: if the output gap is negative, there's slack in the economy, so inflation will eventually fall on its own. You don't need to keep rates high. Luna: That makes sense. But I've heard critics say the output gap is just a made-up number that justifies whatever policy central bankers want. Lucas: That's the controversy. Potential GDP is unobservable — you can't walk into a factory and measure it. It's estimated from statistical models that strip out temporary shocks. And different models give wildly different readings. The Congressional Budget Office in the US, for example, often revises its potential GDP estimates years later. Luna: So how do central banks decide which model to trust? Lucas: They use a range. The ECB looks at multiple estimates — from its own staff, from the OECD, from national central banks. If they all point in the same direction, policymakers feel more confident. But if they diverge, it becomes a judgment call. And that's where you see hawks and doves arguing. Luna: I think a lot of our listeners might wonder: why not just look at unemployment or wage growth instead of this abstract gap? Lucas: Great question. Those are related. The output gap is essentially the real-side twin of the unemployment gap — the difference between actual unemployment and the natural rate. But the output gap captures more: it includes underemployment, productivity, capital utilization. It's a more comprehensive measure of slack. Luna: And it feeds into the neutral rate — the rate that neither stimulates nor restricts the economy. Lucas: Exactly. If the output gap is positive and persistent, the neutral rate likely rises because the economy needs more cooling. That's what happened in the US in 2023 — the Fed revised up its estimate of the neutral rate partly because the output gap stayed positive longer than expected. Luna: So the output gap isn't just backward-looking — it's a forward-looking input for where rates should go. Lucas: Right. And that's why it matters for investors. If you hear a central banker say 'the output gap is closing' or 'there's more slack than we thought,' that's a signal about the future path of rates. Luna: Alright, let's zoom in on the ECB case. You mentioned Germany. Walk me through how the output gap affected actual policy. Lucas: Sure. In December 2024, the ECB's staff projected the output gap for 2025 at minus 0.3 percent. That was a big shift from plus 0.5 percent just six months earlier. The revision was driven by Germany's industrial recession — manufacturing output had fallen for four straight quarters. Luna: And the ECB started cutting in January 2025. Lucas: They did. President Lagarde specifically referenced 'weakening demand and rising slack' in the press conference. She didn't use the exact words 'output gap,' but that's what she meant. The rate cut was 25 basis points. Luna: But critics said inflation was still at 2.8 percent — above the 2 percent target. Cutting seemed premature. Lucas: That was the debate. The hawks argued that a negative output gap was speculative — that maybe potential GDP had actually fallen due to deindustrialization, so the gap wasn't really negative. If potential GDP is lower, then the same output means less slack. Luna: So the measurement problem gets compounded by structural changes. Lucas: Exactly. That's the hysteresis risk — a recession can permanently reduce potential output by destroying capital and scarring workers. If that happened in Germany, the output gap might be smaller than the models say. That would make rate cuts inflationary. Luna: This is really the heart of the controversy: the output gap is a model output, but the model might be wrong about the underlying structure. Lucas: Yeah. And there's another layer: the output gap depends on the natural rate of unemployment, which is also unobservable. So you're stacking two estimates on top of each other. Luna: That sounds like a recipe for error. Lucas: It can be. But central banks don't have a better alternative. They need some framework to decide whether the economy needs stimulus or restraint. The output gap, for all its flaws, provides that framework. It's better than pure gut feel. Luna: One thing I've noticed: in the US, the Fed seems to talk about the output gap less than the ECB. Is that cultural? Lucas: Partly. The Fed's dual mandate — maximum employment and stable prices — leads them to focus more on labor market metrics. The ECB has a single mandate: price stability. But they interpret that as requiring an assessment of the output gap because inflation is driven by slack. Luna: So the output gap is a tool for both, but it features more prominently in the ECB's narrative. Lucas: Yes. In fact, the ECB publishes a quarterly output gap estimate in its staff macroeconomic projections. The Fed doesn't publish its own — they rely more on private sector estimates. Luna: That transparency might actually help markets understand their thinking. Lucas: It does. When the ECB cut rates in January, markets had already priced in the move because the output gap forecasts had been steadily revised down. The output gap acted as a communication tool. Luna: But if the output gap is so uncertain, why do markets trust it? Lucas: They don't blindly trust it — they watch the revisions. If the ECB consistently revises the output gap down, markets infer that easier policy is coming. The trend matters more than the level. Luna: That's a good practical takeaway for investors: don't obsess over the number, watch the direction of revisions. Lucas: Exactly. And that's true for all central bank forecasts — not just the output gap. The dots are less important than the dots shifting. Luna: Let me ask you a hypothetical. Suppose the output gap is deeply negative — say minus 3 percent — but inflation is at 4 percent from supply shocks. Do you still cut rates? Lucas: That's the classic supply-shock dilemma. Most central banks would look through the temporary inflation and cut, because the output gap signals weak demand. The ECB did something like that in 2014-2015 when inflation was low but the output gap was huge. They cut rates and launched QE. Luna: But the 2021-2023 period was the opposite: a positive output gap with supply-driven inflation. They hiked. Lucas: Right. So the output gap helps distinguish between demand-pull and cost-push inflation. If the gap is positive, demand is driving prices — raise rates. If the gap is negative even with high inflation, it's probably supply-side — tighten less or not at all. Luna: That framework is incredibly useful. But I want to push back: what about the 1970s? Central banks had output gap estimates then and still got inflation wrong. Lucas: Fair point. The 1970s output gap estimates were crude — often just linear trends. They didn't account for the oil shocks properly. Modern models are more sophisticated, using production functions and filtering techniques. But they're still not perfect. Luna: So the output gap is a compass, not a GPS. Lucas: That's a great way to put it. It gives you a general direction, but you still need to steer around obstacles. Luna: And central bankers are the pilots, not the autopilot. Lucas: Exactly. And as listeners think about the next few years, watch the output gap estimates from major central banks. If they start widening negative, expect rate cuts. If they flip positive, expect hikes or holds. Luna: One last thing: where can our audience learn more about how these estimates are calculated? Lucas: The OECD publishes a detailed methodology on its website. Also, the ECB's occasional paper series has a great paper from 2021 called 'Output gap measurement in the euro area.' It's wonky but accessible. Luna: Perfect. I think we've given listeners a solid framework to understand why central bankers keep talking about this abstract concept. Lucas: Yeah. It's abstract — but it's also the foundation for the biggest financial decisions in the world.