What The U.S. Output Gap Is Telling Us

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by: MacroForce
Summary

Studying the business cycle can provide a glimpse into the timing of the next economic downturn. The difference between current output and the economy’s long-term potential may hold they key.

In the past 10 recessions, the output gap had closed prior to the onset; like clockwork.

History tells us it is not time to hit the panic button just yet.

For those carefully watching central bank policy-making; trying to predict the next move in short-term rates, the closing of the output gap may be quite telling.

Studying the stage of the business cycle can provide a glimpse into the timing of the next economic downturn. The difference between current output and the economy’s long-term potential may hold the key.

A Quick Refresher for Those with Macro 101 Far in the Rear View

The output gap is a measure of the spread between the actual growth of the economy and its potential growth. The level of potential growth is what economic output could be if all resources were being utilized at their long term sustainable rate, such as the supply of workers and productivity.

When the actual level of economic output is below its potential – the start of which is usually triggered by a recession - there is said to be spare capacity in the economy, as supply side factors work to catch up. Inflationary pressures are thus weaker during periods with a negative output gap. During an economic boon, the output gap closes and when the output gap surpasses its break-even level and is positive, economic growth is above its potential as the economy overheats. Overheating results in strong inflationary pressures as prices rise in response to heightened demand forces.

Clearly a positive output gap is not sustainable and the ideal level is when economic growth is humming along at its potential level and all other variables such as inflation and employment are at their natural long run levels. It is also intuitive to see that co-movement among a positive output gap and rising inflation can spell trouble if the central bank must work to cool the economy by tightening via higher interest rates or otherwise.

Where Are We Now?

The most recent data from June 2017 using the CBO’s estimate of nominal potential GDP relative to the actual levels of nominal GDP growth show that the U.S. economy was still running with approximately 0.16% of spare capacity. However, given the strength in the most recent GDP print, that gap has likely now closed.

In the past 10 recessions (counting the economic dead cat bounce of 1980/81 as one) dating back to the early 1950s, the output gap had closed prior to the onset of the recession in every single instance; like clockwork.

But this doesn’t mean it’s time to hit the panic button just yet. What history also teaches us is that the economy can run above its long-term potential for extended periods. In other words, the output gap can remain in positive territory for quite some time prior to the onset of a recession. Prior to the recession that began in April of 1960, the output gap closed approximately 9 months before. The output gap closed about 69 months (nearly 6 years) before the recession that started in the last quarter of 1969. These are the two extremes. The average has been about 29 months, and 20 prior to the most recent recession.

Source: Bloomberg and the St. Louis Fed

The timing of the next economic downturn will be based on many factors aside from just the level of economic output, however, these factors are related. The growing demand forces that contribute to strengthening economic growth also result in inflationary pressures. Similarly, this can also contribute to a tightening labor market which also impacts prices as wages can theoretically rise. The closing of the output gap provides some evidence of healthy demand and a strengthening economy. The fact this is materializing while labor market dynamics are also very strong suggest that the final piece of the puzzle – rising prices - may be just over the horizon; the presence of which may escort us into the next stage of the business cycle.

What Else We Can Take Away

For those carefully watching central bank policy-making; trying to predict the next move in short-term rates, the closing of the output gap may be quite telling given the Fed’s dual mandate of maintaining full employment and to achieve stable inflation. An output gap of zero theoretically implies that full employment has been achieved as the economy is running at its full potential. Expectations for upward pressure on inflation may increase if incoming data also begins to suggest that economic output will continue to march higher above its long run potential. At the least, central bankers may turn more hawkish in coming months.

In closing, there is no one indicator with a hard and fast rule to predicting the timing of peaks and troughs in the business cycle. As acknowledged earlier, studying the output gap can assist in developing a better understanding of the drivers behind other economic variables; and also help anticipate future developments. This needs to viewed with respect to other related factors such as labor market statistics, the yield curve and inflation.

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