The constant revision of estimates of potential output and thus of the output gap also underscore one of the difficulties policymakers have in trying to use gaps as a guide to policymaking in real time. Indeed, Athanasios Orphanides and Simon van Norden have argued that a major problem that gave rise to the great inflation of the 1970s was the mismeasurement of the perceived output gap. They explained how the Fed consistently relied on estimated output gaps that were subsequently revised and ended up being much smaller than initially thought. They argue that policymakers' reliance on estimated gaps led to overly expansionary monetary policy and the resulting high rates of inflation.

Although the Federal Reserve, like other forecasters, has tended to be overoptimistic in its forecasts of real GDP during this recovery, we have also, at times, been too pessimistic in our forecasts of the unemployment rate. For example, over the past year unemployment has declined notably more quickly than we or other forecasters expected, even as GDP growth was moderately lower than expected a year ago. This discrepancy reflects a number of factors, including declines in participation, but an important reason is the slow growth of productivity during this recovery; intuitively, when productivity gains are limited, firms need more workers even if demand is growing slowly. Disappointing productivity growth accordingly must be added to the list of reasons that economic growth has been slower than hoped.17 (Incidentally, the slow pace of productivity gains early in the recovery was not evident until well after the fact because of large data revisions--an illustration of the frustrations of real-time policymaking.) The reasons for weak productivity growth are not entirely clear: It may be a result of the severity of the financial crisis, for example, if tight credit conditions have inhibited innovation, productivity-improving investments, and the formation of new firms; or it may simply reflect slow growth in sales, which have led firms to use capital and labor less intensively, or even mismeasurement. Notably, productivity growth has also flagged in a number of foreign economies that were hard-hit by the financial crisis. Yet another possibility is weak productivity growth reflects longer-term trends largely unrelated to the recession. Obviously, the resolution of the productivity puzzle will be important in shaping our expectations for longer-term growth.

There appears to be widespread confidence that the Federal Reserve will keep inflation low and stable, consistent with our announced inflation goal of 2 percent. Indeed, most forecasters view the current readings on inflation to be a temporary phenomenon and expect inflation to run at or a little below 2 percent over the next few years. Household surveys and financial market measures also indicate that inflation is expected to remain near its longer-term average. My own view is that the transitory factors depressing inflation are likely to ebb, and we’ll see inflation edge back toward the Federal Open Market Committee’s target of 2 percent by next year.

... Looking ahead, the key question regarding the economic outlook is whether growth will remain relatively low. Many forecasters expect growth to pick up to over 3 percent next year. I have become increasingly persuaded, however, that low growth rates are likely to persist for several years.

...the slow growth in real GDP in this expansion is related to both lower productivity growth and lower employment growth. While economists understand the principles underlying productivity growth, it’s quite difficult to parse the causes of medium-term swings in productivity growth, particularly as they are happening. At this juncture, low productivity growth has persisted long enough that I think the best guess is that it will remain low for an extended period.

Looking forward, my personal forecast for output growth is similar to the Blue Chip consensus. I believe the most likely scenario is that real GDP will advance at a low, but positive, rate in the second half of this year followed by trend-like growth in 2010. A forecast that the economy will soon switch from contraction to expansion strikes some people as optimistic. But, it takes less than you might think for real GDP growth rates to turn positive. Positive growth becomes likely if some of the economy’s weak sectors stop dragging down GDP going forward.

To sum up the story on the outlook for real GDP growth, my own view is that, under appropriate monetary policy, the economy is still likely to achieve a relatively smooth adjustment path, with real GDP growth gradually returning to its roughly 2½ percent trend over the next year or so, and the unemployment rate rising only very gradually to just above its 4¾ percent sustainable level.    

Despite the positive readings on recent economic performance outside the housing sector, my forecast calls for below trend, slower GDP growth in the fourth quarter of 2007 and first half of next year. This forecast anticipates further weakness in housing in the near term and the likelihood that declines in housing wealth will contribute to a weakening of the pace of consumer spending.  

The financial market turmoil that began in August hit hard an already struggling housing market. Financial markets appear to be stabilizing, but they have not returned to normal and are still fragile. Most forecasters have reduced their expectations for GDP growth and believe that downside risks have risen. However, the employment report for September, the latest available at this time, does not suggest that the downside risk is occurring. As an aside, the substantial upward revisions to data released in the August report remind us that it is a mistake to place too much weight on any one report.

At this early juncture in 2007, I think it entirely reasonable to expect the economy to maintain an average pace of 3 percent growth for the year. And, if we at the Fed do our job well, we should be able to accommodate that growth rate while bringing inflation down below 2 percent

Growth will start the year on the low side, but should be back to about 3 percent by the end of the year. So my best guess right now is that real GDP growth will average between 2 ½ and 2 ¾ percent in 2007.  A month or two ago, this forecast would have been somewhat higher than the consensus of widely quoted analysts. But the data since then have been stronger than most observers expected, particularly the very robust data on consumer spending and employment. As a result, many analysts have marked up their forecasts, and so the projections I’ve presented today are now fairly mainstream.

The outlook for real growth in 2007, then, is for continued strength in consumer spending and business investment to be partially offset, particularly early next year, by the drag from the housing market.  Growth will start the year on the low side, but should be back to about 3 percent by the end of next year.  So my best guess right now is that real GDP growth will average between 2 ½ and 2 ¾ percent in 2007. 

'[Q3 GDP] was a little stronger than I expected. Housing was a big drag. Business-side spending was pretty good. We are still not seeing spillover from housing.''

"I am expecting growth to return to potential sometime next year.''

"I am not hopeful a lot of slack is going to open up before we return to trend."

As reported by Dow Jones

I expect second-quarter GDP growth to be revised upward to closer to 3 percent. And my best guess one month and two weeks into the third quarter is that the speed at which we are now proceeding is roughly of that magnitude. From my vantage point, despite what you hear from some of the Eeyores in the analytical community, a recession is not visible on the horizon.

With overall population growth continuing to slow and labor force participation not expected to rise, we probably need to adjust our benchmarks for what level of employment growth is consistent with economic growth near potential and a steady unemployment rate. It used to be that increases in payroll employment that averaged 150,000 per month were consistent with flat unemployment. Now that number may be closer to 100,000. These developments also imply that, in the absence of changes in productivity growth, our estimates of potential GDP growth should be revised down 2 or 3 tenths of a percentage point to a range of 3 to 3-1/4 percent.

We at the Chicago Fed think that after a strong rebound in the first quarter of 2006, real GDP growth will average somewhat above three percent over the next couple of years. We expect that the unemployment rate will change little from its current level and that inflation will remain contained. However, inflation currently is near the upper end of the range that I feel is consistent with price stability. As such, I believe monetary policy must be vigilant. We need to make sure that increases in resource utilization or prices of energy and other commodities do not add to inflationary pressures or increase inflation expectations.

Over the longer-term, if we want to keep improving our standard of living, we must make sure that productivity growth remains robust. Faster productivity growth generates faster GDP growth. This boosts our well-being. It also helps make the adjustments to the current account and fiscal deficits a much smoother process than if we were facing them from a base of lower GDP growth.