At a time when there’s more uncertainty than usual about what the U.S. Federal Reserve will do next and when the next interest raise will be, there’s even more talk about the economy’s potential. Where could the nation’s gross domestic product could be? How would a healthier consumer impact potential GDP?
What is potential GDP?
Of course it’s hard to measure potential, even for central bankers, and for the average investor, ideas like potential GDP are even more difficult to grasp because it all comes down to how these theoretical numbers are “measured.” UBS economist Robert Sockin and team offered a report explaining the concept of potential GDP, including how it’s estimated and why it’s important.
They describe potential GDP as “the theoretical level of output when resources are fully utilized.” For example, if the U.S. were at full employment, what would the results be, compared to where they are right now? The UBS team explains that central bankers use potential metrics to determine where the economy stands. For example, resources become stretched at times when the markets are higher than the potential level, so economists can anticipate accelerating inflation when they see this.
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On the other hand, when output is not meeting its potential, inflation will decelerate because there’s slack in the economy. One of the big debates recently is about how much slack currently exists in the U.S. economy. Many economists are concerned that slack is shrinking dramatically, while a few argue that there’s actually still plenty of slack left.
How potential GDP is estimated
Calculating potential GDP is essential for all central banks because it enables them to set policy. Policymakers must be able to estimate where GDP could be and then compare it to where it actually is. According to Sockin, central banks “spend considerable time” trying to estimate it, and there’s a nearly endless list of ways to do so. He classifies the main ways of calculating it into three groups.
One group is univariate methods, which he describes as estimating potential “directly from GDP using statistical filtering techniques.” The second group is multivariate, which examine various “economic relationships to impose structure on the statistical filtering procedures.” The third is “production function or growth accounting frameworks, which build up to an estimate of potential from estimates of the underlying factors of production.”
Little trust in the results
Sockin prefers the growth accounting method because it “imposes economic structure on the data in a manner that also gives a view on the potential levels of labor, capital, and total factor productivity.” But no matter what type of technique is used, he sees the result of the calculation as questionable at best.
“Filtering techniques perform notoriously poor at the end of the sample, data revisions can alter previous estimates, and all models require heavy assumptions such as the stability of underlying relationships and trends,” he explained.
Despite this, he feels that it is absolutely necessary to estimate the potential of a nation’s gross domestic product. He believes it’s important to compare the estimates against hard economic measures like unemployment and inflation.
“Assessing the state of the economy is part statistical, part economics, and part judgment and intuition,” he concludes.
Indeed, "inflation" has been a keyword over the last year or so as the Fed has tried to get inflation to reach a specific level, but the U.S. economy hasn't been behaving. As a result, the Fed has been sending mixed signals about what it's going to do next, so much so that investors stopped believing policymakers when they said an interest rate hike was imminent.
A lesson from Hurricane Harvey
Hurricane Harvey offers an example of how economists use judgment and intuition to gauge the impact on the national GDP, even as only two states are feeling its enormous impact. IHS Global Insight economist Patrick Newport told U.S. World News and World Report that although many homes were destroyed, causing a drag on their local economies, repairing them will cause a burst of activity that will boost GDP.
Similarly, Cornell University macroeconomic policy expert Steven Kyle said in a statement on Monday that natural disasters like Harvey cause “destruction of capital assets” followed by “a burst of economic activity as these are rebuilt.” However, he noted that the actual GDP only measures the rebuilding effort and does not include the losses that occurred before that effort began.
Potential GDP, on the other hand, may include things like lost wages or income due to businesses being closed. For example, if economists were to estimate Texas’ or Louisiana’s potential GDP in the wake of Hurricane Harvey, some formulas may include the destruction as a factor when determining where it could be as the states deal with the aftermath. Insurance companies will take a hit repairing all the damage, and investors already planned ahead by selling off insurance stocks on Monday.