Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Watching the Output Gap Again
Transcript
- Lucas: If you've been following central banks at all this year, you've probably heard them talk about the 'output gap' more and more. The Bank of England mentioned it in their July policy statement, the ECB keeps circling back to it in speeches, and even at the Fed, you've got governors like Christopher Waller saying the output gap may be smaller than the models suggest. So what exactly is this thing, and why does it matter right now? Luna: And just to be clear — we're not talking about something like the trade deficit or the fiscal gap. This is specifically about the difference between where the economy actually is and where it could be if all resources were fully employed. Lucas: Exactly. The output gap is real GDP minus potential GDP. If actual output is below potential, you have a negative output gap — slack in the economy. If actual is above potential, you have a positive output gap, which usually signals overheating. And central banks care about this because a positive output gap tends to push inflation up, while a negative one pulls it down. It's a core input into the Phillips Curve framework. Luna: Right, but measuring potential GDP is the tricky part. It's not like we can just look it up in a database. How do central banks actually estimate it? Lucas: There are two main approaches. The first is the production function approach — you estimate the economy's potential based on labor, capital, and productivity trends. The Congressional Budget Office does this for the U.S., and they publish a quarterly estimate of potential GDP. The second is statistical filtering — the Hodrick-Prescott filter is the classic one — which basically smooths the GDP data to extract a trend. The problem is, both methods have huge uncertainty bands. At the end of 2021, most models showed a substantial negative output gap in the U.S. even though inflation was already running hot. That turned out to be a serious miss. Luna: So the output gap can give you misleading signals if your estimate of potential is wrong. And that's exactly what happened — potential GDP may have been lower than models thought because of pandemic-related scarring to the labor force and supply chains. Lucas: Right. A lot of economists now believe that potential GDP took a permanent hit from the pandemic — lower labor force participation, lower productivity growth in some sectors — so the economy hit its capacity constraint sooner than the models predicted. That's one reason inflation surged in 2022-2023 even though output was still below pre-pandemic trend. The output gap was probably positive earlier than anyone realized. Lucas: Fast forward to July 2026, and we're in a different situation. The U.S. economy has been growing above trend for about four quarters now. The unemployment rate is 3.8 percent, core PCE inflation is hovering around 2.7 percent. The Fed has kept rates at 4.5 percent since March. And the debate now is: is the output gap positive enough to warrant another hike, or is it close to zero, meaning the economy is roughly at potential and further tightening could cause unnecessary damage? Luna: And that's where the uncertainty bites. The CBO estimates the U.S. output gap at about plus 0.5 percent of GDP. But the San Francisco Fed's own model puts it at plus 1.2 percent. Those are very different implications for policy. Lucas: Exactly. If the CBO is right, the economy is only a little above potential — maybe we can let inflation drift down on its own. If the SF Fed model is right, we're significantly above potential, and the risk is that inflation reaccelerates. The Fed is essentially flying blind on this one metric. And that's why you hear Chair Powell talking about 'data dependence' so much — they're looking at every other indicator because the output gap is too uncertain to lean on heavily. Luna: Now let's talk about the other side of the Atlantic. The eurozone — much weaker growth. GDP grew only 0.3 percent in the first quarter, and the ECB's own estimates suggest a negative output gap of around minus 1.5 percent. So why isn't the ECB cutting rates more aggressively? Lucas: That's the puzzle. The ECB started cutting in June — they went from 4.25 percent to 3.75 percent — but they've been cautious because services inflation is still sticky at 4.1 percent. Their concern is that even with a negative output gap, wage growth and profit margins are keeping inflation above target. So they're weighing the output gap against other measures of underlying inflation. It's a reminder that the output gap is just one input — it doesn't override everything. Luna: It also depends on how you define potential. The ECB uses a multivariate filter that includes the unemployment rate and capacity utilization, not just GDP. Their estimate of potential output for the eurozone has actually been revised down since 2022 because of the energy shock and weaker investment. So a given level of GDP now represents more slack than it would have five years ago. Lucas: That's a crucial point. The output gap is not a fixed number — it changes as the economy's structure changes. And that's why critics say central banks should be cautious about using it as a policy guide. I mean, look at the Bank of Japan. They've had a negative output gap for most of the last three decades, but they've also had periods of deflation and periods of mild inflation. The relationship between the output gap and inflation is just not stable over long periods. Luna: So if it's so unreliable, why do central banks keep using it? Honestly, if walking through the economy with us has made something click for you, that's great — and if today's episode was worth a coffee, there's a link at buy me a coffee dot com slash fexingo. We keep this show ad-free, and listener support is what makes that possible. So yeah, just a small way to say this is valuable. Lucas: Appreciate that, Luna. And to answer your question — they keep using it because they need a framework. Without some estimate of potential, you can't tell whether current growth is sustainable or inflationary. The output gap is flawed, but it's better than nothing. And central banks are getting better at triangulating — they look at multiple models, they look at labor market tightness, they look at capacity utilization, they look at survey data on supply constraints. The output gap is one piece of a larger mosaic. Luna: And there's a new approach gaining traction — using real-time data like job vacancies and quits rates to estimate slack more directly. The Fed's own 'vacancies to unemployment ratio' has become a popular alternative. It's simpler and arguably more timely. Lucas: That's a great point. The Beveridge curve — the relationship between vacancies and unemployment — shifted after the pandemic. For a given unemployment rate, there are more vacancies now than there were pre-2020, which suggests a tighter labor market than the unemployment rate alone implies. That's one reason some Fed officials think the output gap is smaller than the CBO estimates. The labor market is telling a different story than the gdp based models. Luna: So what does this mean for investors or business leaders listening? Should they be watching the output gap? And if so, which estimate should they trust? Lucas: I'd say don't fixate on any single number. Watch the range. If the CBO and the San Francisco Fed are a full percentage point apart on the output gap, that tells you the uncertainty is high. That uncertainty itself is a reason for central banks to move cautiously. For investors, the key takeaway is that the Fed is likely to be patient — they're not going to hike aggressively based on a model they don't fully trust, and they're not going to cut aggressively if they think the economy might be above potential. So expect rates to stay where they are for longer than the market might price. Luna: And for the ECB, with a negative output gap but sticky services inflation, the bias is toward gradual easing. They'll cut maybe once more this year, but they won't rush. Lucas: Exactly. The output gap is a useful concept — it forces you to think about supply and demand in the whole economy. But it's not a precision tool. It's more like a weather vane than a thermometer. It tells you the direction of the wind, but not the exact temperature. And in July 2026, that wind is blowing in different directions on both sides of the Atlantic. Luna: So we'll keep watching the data — and the output gap revisions. Thanks for listening, and if you found this useful, you know where to find us.