Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use the Output Gap to Set Policy
Transcript
- Lucas: So the Federal Reserve has a meeting coming up at the end of this month, July twenty-eighth and twenty-ninth. And one of the quieter numbers that will be sitting in front of every committee member is something called the output gap. Luna: The difference between where the economy actually is and where it could be if everything were running at full capacity, right? Lucas: Exactly. Potential GDP is the fancy term for that 'could be' number. And the gap — positive or negative — gives the central bank a read on whether the economy is running hot or cold. In mid-2026, the U.S. output gap is estimated to be somewhere around half a percent of GDP on the positive side. That's small, but positive. Luna: So we're slightly above potential, meaning demand is a little stronger than supply. That usually puts upward pressure on wages and prices eventually. Lucas: Right, and that's exactly why the Fed watches it. If the output gap is positive and widening, that's a signal to keep rates restrictive or even tighten more. If it turns negative — meaning there's slack — they might start thinking about cutting. Luna: But how do they even know what potential GDP is? It's not like there's a gauge on the economy. Lucas: That's the billion-dollar question. Potential output is unobservable. You have to estimate it using models. The Congressional Budget Office, or CBO, publishes its own estimate every year. As of early 2026, the CBO pegged potential U.S. GDP at about twenty-nine point three trillion dollars in nominal terms. Actual GDP has been running a bit above that, maybe twenty-nine point five or so. Luna: So less than one percent difference. That's a thin margin for making big policy decisions. Lucas: It is. And that's why the output gap is controversial. Different models give different numbers. The CBO uses a production-function approach — labor, capital, productivity — and it tends to be conservative. The San Francisco Fed has its own measure that sometimes shows a bigger gap. In early 2026, the SF Fed's output gap was around one point two percent. Luna: So depending on which number you trust, the economy is either slightly above potential or clearly above potential. That's a meaningful difference for where rates should be. Lucas: Exactly. And this connects directly to the Taylor Rule, which we talked about in Episode 103. The Taylor Rule uses the output gap as one of its two key inputs, alongside inflation. If you plug in a small output gap, you get a lower recommended rate. A larger gap pushes the recommended rate higher. Luna: And then there's the interaction with r-star, the neutral rate of interest. We covered that in Episodes 87 and 88. Lucas: Right. R-star is the real rate that neither stimulates nor restrains the economy when it's at potential. But if the output gap is positive, the actual real rate needs to be above r-star to cool things off. So the gap tells you how far above neutral you need to be. Luna: Let's talk about a real example. In 2023, the U.S. output gap was still negative in many estimates — around minus one percent. The economy had room to grow. By 2025, it flipped positive. And the Fed kept rates high even as inflation fell. That connection makes sense now. Lucas: Yeah, the output gap is one reason the Fed didn't cut rates faster in 2024 and 2025. They saw demand running ahead of supply, and they wanted to be sure inflation wasn't going to reignite. Even if headline CPI was coming down, the gap suggested underlying pressure. Luna: But there's a flip side. If you get the output gap wrong, you could keep rates too high for too long and push the economy into a recession. That's the risk. Lucas: Absolutely. The classic example is the euro area after the 2011 debt crisis. The European Central Bank thought the output gap was small, so it raised rates. It turned out the gap was much wider, and the economy slipped back into recession. Getting the estimate right really matters. Luna: So how do central banks deal with that uncertainty? Do they just pick one model and hope for the best? Lucas: No, they typically look at a range. The Fed's staff produces its own estimate, and the committee members see multiple models. Some policymakers put more weight on the labor market as a proxy. If unemployment is below the natural rate — like it is now, at three point nine percent versus a natural rate estimate of maybe four point two — that's a sign the output gap is positive. Luna: So there's a cross-check. Labor market data, capacity utilization, business surveys. They triangulate. Lucas: Exactly. And let's not forget that potential GDP itself can change. If productivity growth picks up because of AI or other tech, potential GDP rises, and the same actual GDP number would represent a smaller positive gap or even a negative gap. That's why the Fed watches productivity data closely. Luna: Right. So the output gap isn't static. It moves with the economy's supply side. And central banks have to constantly update their view. Lucas: If today was actually useful to you — understanding how central bankers think about the output gap — the way these shows stay ad-free and independent is listener support. You can buy me a coffee for Lucas and Luna at buy me a coffee dot com slash fexingo. Luna: Yeah, it really helps. We put a lot of research into each episode, and knowing that listeners find it valuable enough to chip in keeps us going. No pressure, just if you feel like it. Lucas: Okay, back to the output gap. One thing I find really interesting is how the concept feeds into the Fed's forward guidance. In their June 2026 statement, they said the economy is 'operating at a high level of resource utilization.' That's central bank speak for a positive output gap. Luna: So they're signalling that they see the gap. And by saying that, they prepare markets for rates staying higher for longer. Lucas: Exactly. And market participants parse those words carefully. If the Fed ever drops that phrase — or says there's 'some slack' — that would be a dovish signal. Luna: Let's zoom out to other central banks. Are they all using the output gap the same way? Lucas: Broadly yes, but with different emphasis. The Bank of Japan has been dealing with a negative output gap for decades, so they've kept rates ultra-low. The ECB has a more fragmented economy, so their potential GDP estimates are especially uncertain — the gap might be positive in Germany but negative in Spain. That makes policy harder. Luna: So the output gap is a great concept, but its practical use depends on how well you can measure it. And for a currency union like the euro area, that's really tough. Lucas: Right. And that's why central banks also rely on other indicators like wage growth and inflation expectations. But the output gap remains a core framework — it's in every economics textbook, and every central banker thinks in those terms, even if they don't say it out loud. Luna: So for the listener who wants to follow along with Fed meetings, what should they watch? Is there a specific number released regularly? Lucas: The Fed doesn't publish its own official output gap estimate, but you can follow the CBO's updates — they release a new one each January, with a mid-year update in July. The San Francisco Fed also publishes a quarterly 'Cyclical Indicators' report that includes their gap estimate. And you can look at the unemployment rate relative to the CBO's natural rate estimate, which is a decent proxy. Luna: So the output gap is one of those behind the scenes numbers that drives a lot of the story. Thanks for pulling back the curtain on it. Lucas: Happy to. It's one of those concepts that, once you see it, you start noticing it everywhere in central bank communication. Next time you hear 'resource utilization' or 'operating near potential,' you'll know exactly what they mean.