Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Obsessed with the Output Gap Now
Transcript
- Lucas: So there's this concept in macroeconomics that central bankers talk about constantly but almost never explain well. It's called the output gap. And right now, it's at the center of a real policy fight at the Bank of England. Luna: The output gap — that's the difference between where the economy actually is and where it could be running at full capacity, right? Lucas: Exactly. It's actual GDP minus potential GDP. If the economy is running hot — actual above potential — you get a positive output gap, which tends to push inflation up. If it's running cold, you get a negative gap, which pulls inflation down. Luna: So it's basically a measure of slack. Or of overheating. Lucas: Right. And the tricky part is that potential GDP isn't something you can observe directly. You have to estimate it. And those estimates can shift. So the output gap is always a judgment call, which makes it politically charged. Luna: And the Bank of England is at the center of this right now because... Lucas: Because the UK economy has been showing a positive output gap for about three quarters now. The Bank's own estimates put potential GDP growth at roughly 1.5 percent a year. But actual GDP has been running around 2.2 percent. So you've got a gap of about 0.7 percentage points. Luna: Which for an economy the size of the UK is tens of billions of pounds of extra output. Lucas: Correct. And that gap is one reason inflation in services has been sticky — it's been hovering around 5.5 percent, well above the Bank's 2 percent target. So the hawks on the Monetary Policy Committee are saying: we need to keep rates high or even raise them further to close that gap. Luna: But the doves are pushing back, I assume. Lucas: They are. And their argument is interesting. They say the output gap estimate is too uncertain to justify tighter policy. The Bank's chief economist, in a speech last month, pointed out that the margin of error around the potential GDP estimate is large enough that the output gap could actually be close to zero. Luna: So the same data can justify two completely different policy stances depending on which estimate you believe. Lucas: That's exactly the problem. And it's not just a UK thing. The European Central Bank is dealing with the mirror image — a negative output gap. The euro area economy has been growing below potential for a while, which is part of why the ECB has been more cautious about raising rates. Luna: But the ECB's negative gap is also an estimate. So the same uncertainty applies. Lucas: Right. And that's where the output gap connects to a bigger debate: how much should central banks rely on these unobservable concepts versus just looking at actual inflation data? Luna: Isn't that the old 'lean against the wind' versus 'just mop up afterwards' debate? Lucas: It is, but the output gap gives that debate a specific numeric anchor. The Bank of England, for example, publishes its own estimate of the output gap every quarter in its Monetary Policy Report. And financial markets watch it closely. If the gap widens, markets price in a higher probability of rate hikes. Luna: So it's not just an academic concept. It has real market consequences. Lucas: Absolutely. Let me give you a concrete example. In May, when the Bank released its quarterly report, it showed the output gap at plus 0.7 percent. Within an hour, the two-year gilt yield rose about 8 basis points. Traders were repricing their rate expectations based on that single number. Luna: Eight basis points is a big move for a single data release. Lucas: It is. And it shows how much weight markets put on the output gap, even though it's just an estimate. The Bank itself acknowledges the uncertainty — it publishes a fan chart around the estimate. But markets tend to focus on the central projection. Luna: So what's the alternative? Could central banks just ignore the output gap and focus on something else? Lucas: They could, but most don't want to. The output gap is a key input into the Taylor Rule, which is a simple formula that many central banks use as a rough guide for where interest rates should be. And the Taylor Rule has been pretty influential, especially at the Fed. Luna: But the Taylor Rule also requires estimates of the neutral rate of interest, which is another unobservable concept. Lucas: Exactly. So you end up with this cascade of estimates. The output gap depends on potential GDP, which depends on things like labor force participation and productivity growth. And those are all uncertain. But central banks still find the framework useful because it forces them to be explicit about their assumptions. Luna: It's like a disciplined way to have the debate. Lucas: Precisely. And that's why, even with all its flaws, the output gap isn't going away. It's too embedded in the policy framework. The question is whether central banks will be transparent about the uncertainty — or whether they'll let the estimate take on a false precision. Luna: And on that note, this kind of deep dive into how central banks actually think — well, it's exactly the kind of thing that makes this show worth supporting. Lucas: Yeah, and a couple of dollars a month genuinely makes a difference. If you've gotten something out of these episodes, you can head to buy me a coffee dot com slash fexingo. It helps us keep the show ad-free and focused on the substance. Luna: And we really appreciate it. So, back to the output gap — one thing that's fascinating is how central banks revise their estimates over time. Lucas: Right. After the 2008 financial crisis, many central banks realized they had been overestimating potential GDP before the crisis. That meant they thought the output gap was smaller than it actually was, which delayed policy easing. Luna: So they learned from that mistake and became more cautious. Lucas: They did. But now some economists argue they've swung too far in the other direction — that they're underestimating potential GDP, which leads them to see positive output gaps that aren't really there, and keeps policy too tight. Luna: So the debate is really about where to draw the line. Lucas: Exactly. And there's a specific case that illustrates this. In 2023 and 2024, the US economy grew much faster than most forecasters expected, but inflation came down. That suggested potential GDP might have been higher than estimated — maybe because of productivity gains from AI and remote work. Luna: So the output gap was mismeasured. Lucas: Right. If you had believed the official estimates, you would have thought the US was overheating. But the actual data said otherwise. So the Fed ended up keeping rates steady while the output gap narrative shifted. Luna: That's a good reminder that the output gap is a tool, not a truth. Lucas: It is. And the best central bankers treat it that way. They use it to organize their thinking, but they don't let it override actual inflation data or labor market conditions. The Bank of England, for instance, has been careful to say that the output gap is just one of many inputs. Luna: So where does this leave us for the rest of 2026? Lucas: I think we're going to see more public debate within central banks about how to measure potential GDP. The Bank of England already has internal disagreements. The Fed has had them too. And as long as the economy keeps surprising forecasters, those debates will only intensify. Luna: And for listeners who want to follow along, the key number to watch is the quarterly output gap estimate in the Bank's Monetary Policy Report. Lucas: Exactly. That and the minutes from the Monetary Policy Committee meetings, where you can see which members are citing the output gap as a reason for their vote. It's one of the best ways to understand where policy is heading. Luna: So the output gap is messy, but it's also unavoidable. Lucas: It is. And that's why it's worth understanding — even if the estimates are always going to be imperfect. Central banks are going to keep using it, and markets are going to keep reacting to it. So you might as well know what they're looking at.