Last week we blogged about how there seems to be more slack in the US economy than is generally perceived. A supporting data point for that thesis was the fact that the CBO estimate of the output gap remains well below previous cycle highs (chart below). However, the Fed has their own model for the output gap and it is telling a much different story (h/t Cornerstone Macro for keying us in on this data)
Backing up a bit, remember that the output gap is an economic measure of the difference between potential GDP and actual GDP. Potential GDP is the maximum economic output an economy can generate when it is at full capacity. Potential GDP is obviously calculated using a model. The classic calculation of the output gap uses a production function and makes assumptions about labor force growth and productivity. This is how the CBO calculates potential GDP and by extension the output gap. The Fed’s model is derived from the Laubach-Williams model which was originally designed to estimate the equilibrium rate of interest. It is essentially a statistical model which extracts information about unobservable variables (like the output gap) in the economy based on observable responses in the economy (such as actual growth or inflation).
So the classical approach to the output gap is indicating that real GDP is still about 1.5% below potential GDP. However, the Fed’s model is indicating that actual GDP is above potential GDP by about 1.3%. Said differently, the Fed’s model is indicating that the output gap has completely closed. Additionally, the Fed’s estimate of potential GDP is well below the CBO’s estimate of potential GDP. This may explain the more hawkish stance the Fed took via the dot plot in the latest FOMC meeting. At the same time, perhaps policies that expand potential GDP (such as tax cuts) will bring the Fed’s model more in line with CBO?
Since the financial crisis, the two models have been at odds and unlike in prior periods, the two models are not converging towards one another. Currently, the growth spread between the CBO model and the Fed’s model is nearly 3%. The Fed’s model has always had a natural bias to a lower potential GDP but historically the spread between the two has only been about 1% on average. At some point these two models should converged. A question we are asking ourselves is whether the Fed is currently too negative on potential growth?
Article by Eric Bush, CFA – Gavekal Capital Blog