[T]he economy's potential output may be lower than previously estimated for some time. This means measures of the so-called output gap, the difference between the level of actual and potential output, will not be as high as they otherwise would be and may be volatile and hard to measure, especially since potential output is inherently unobservable.

...

I put less weight on output gaps or other measures of slack as predictors of inflation, which is consistent with both theory and empirical estimates from a variety of economic studies.⁴ ...I am not convinced that the size of the output gap is nearly as big as suggested by others for reasons I just discussed.⁵

These last two points seem particularly appropriate and consistent with work that demonstrates the pitfalls of depending too much on measures of the output gap, which empirical studies have shown are not reliably measured in real time.⁶ Indeed, one study found that ex post revisions of the output gap are of the same order of magnitude as the output gap itself — which means that a data revision could make an output gap disappear.⁷ Since it is particularly hard to measure the output gap near business cycle turning points, making policy decisions based on measures of such gaps becomes problematical.

One striking statistic suggests the magnitude of the opportunity that is before us in restoring our economy to its potential. Earlier this week, the Dow Jones Industrial Average, adjusting for inflation according to the standard Consumer Price Index, was at the same level as it was in 1966, when Brookings scholars Charlie Schultze and Arthur Okun were helping to preside over the American economy.

While there could be many ways to question this calculation, that the market would be at essentially the same real level as it was in 1966 when there were no PCs, no internet, no flexible manufacturing, no software industry, and when our workforce was half and our net capital stock was a third of what it is today, may be regarded by some as the sale of the century. For policy-makers, it suggests the magnitude of the gains from restoring sustained economic growth.

Empirical work on inflation, including much of the classic work on Phillips curves, has generally treated changes in commodity prices as an exogenous influence on the inflation process, driven by market-specific factors such as weather conditions or geopolitical developments.  By contrast, some analysts emphasize the endogeneity of commodity prices to broad macroeconomic and monetary developments such as expected growth, expected inflation, interest rates, and currency movements.  Of course, in reality, commodity prices are influenced by both market-specific and aggregate factors...

I have only mentioned a few of the issues raised by commodity price behavior for inflation and monetary policy.  Here are a few other questions that researchers could usefully address:  First, how should monetary policy deal with increases in commodity prices that are not only large but potentially persistent?  Second, does the link between global growth and commodity prices imply a role for global slack, along with domestic slack, in the Phillips curve?  Finally, what information about the broader economy is contained in commodity prices?  For example, what signal should we take from recent changes in commodity prices about the strength of global demand or about expectations of future growth and inflation?

An inability to measure the output gap in real time obviously limits the usefulness of the concept in practical policymaking.  On the other hand, to argue that output gaps are very difficult to measure in real time is not the same as arguing that economic slack does not influence inflation; indeed, the bulk of the evidence suggests that there is a relationship, albeit one that may be less pronounced than in the past.⁷ 

[T]he level of output relative to potential output, which is referred to as the output gap, plays an important role in the inflation process.  When the actual level of output is above potential output--so that the output gap is positive--labor and product markets are excessively tight; then, if things such as expected inflation and temporary supply factors are held constant, inflation will tend to rise.  Conversely, when the output gap is negative and labor and product markets are slack, inflation will tend to fall. 

For better or worse, we cannot escape the need for information on output gaps so that we can forecast the future path of inflation and evaluate the current setting of our monetary policy instruments.  However, we also need to recognize that because measures of potential output and output gaps are so uncertain, we must always be aware that they might be providing misleading signals as to the future course of inflation and the appropriateness of the stance of policy.  In assessing whether there is slack in the economy, we at central banks look not only at our estimates of output gaps but also at a wide range of indicators drawn from the labor, product, and financial markets to provide us with a perspective on the balance of supply and demand in the economy...

The bottom line is that we must never take our eye off of the inflation ball. 

In particular, over the past few decades the natural unemployment rate and the path of potential output have apparently moved around quite substantially. If we do not recognize the potential for such shifts, they can pose serious pitfalls for the conduct of monetary policy...

To be sure, central banks need to form some views about the economy's potential to produce on a sustained basis. After all, as I have already noted, the amount of slack in the economy is a key determinant of inflation. But, rather than focusing on fixed estimates of potential output or the natural rate of unemployment, central banks should take an eclectic approach in assessing the overall balance of economic activity relative to productive capacity. In other words, in pursuing the dual mandate, the central bank should recognize that a wide variety of indicators drawn from labor, product, and financial markets provide information about the overall balance of supply and demand in the economy. In addition, central banks should use information from various price indicators to tell them whether the economy is overheating or running well below productive capacity.

[O]ne recent study even purports to show that foreign output gaps are more important in explaining domestic inflation in industrialized countries than domestic factors (Borio and Filardo, 2006). However, this result has been challenged by the Federal Reserve staffers, who find that estimates to this effect are fragile.⁷

I was not entirely persuaded by the authors’ arguments ... that rely on “new estimates of real-time output gaps,” a bit of an oxymoron given that you cannot really produce a new real-time estimate of a constructed series like the output gap.  Perhaps the gap series produced by the Council of Economic Advisers was viewed skeptically by some contemporary observers, but it was the “official” series published by the Commerce Department, and it was referred to by the Federal Open Market Committee (FOMC) in its policy deliberations.  It does not surprise me that forecasters took several years to catch up to the adverse developments in trend productivity and the demographic factors that boosted the NAIRU; in the 1990s, we took a while to realize the implications of favorable movements in both variables even though we were aware from the experience of the 1970s that such changes were possible.

Recently, however, several researchers affiliated with the Bank for International Settlements (BIS) have reported results favorable to the global output gap hypothesis (Borio and Filardo, 2006). Using data for sixteen industrialized countries (plus the euro area) for 1985-2005, they found significant effects of the global output gap on domestic inflation rates--indeed, effects that were generally larger than those of domestic output gaps and that were rising over time. This provocative result has in turn been challenged by Federal Reserve Board researchers, who find that the empirical support for a role for the global output gap does not survive modest changes in the way the data are analyzed. As domestic output gaps are difficult to measure, even with the benefit of hindsight, it is perhaps not surprising that measuring and assessing the effects of a global output gap have proved contentious.

"To the extent that there is a relationship between economic slack more broadly, and I mean not just labor market conditions, but capital and product market conditions as well, it's become a much weaker relationship. That is, the relationship between slack and slower inflation is clearly lower than it used to be. So that connection is much weaker and there are other factors that seem to play an important role.''

     ``The other problem with using this natural rate concept actively is that a lot of research, some of it at the Federal Reserve Board, has shown that in real time we have a really hard time determining what the natural rate is, if such a thing exists.

     ``And in particular, with demographic changes, changes in the labor market, all kinds of other things, you wouldn't expect a measure of slack to be constant. So what we do at the Federal Reserve is, we really have to be very eclectic.''

     ``We don't rely on any single indicator, on any single measure. We look at a wide variety of indicators.''

     ``The economy is just too complicated now to rely on any single indicator.''

From the audience Q and A session, as reported by Bloomberg News

Still, given the probability of some tightness, we would need to see real GDP growth remain moderately below its long-run trend for a time to have confidence that the economy is heading for a soft landing with inflation continuing to move lower.

One of these risks, as I’ve noted earlier, is the possibility that we might be underestimating the likely pace of economic activity.  If we get an upside surprise on GDP growth, then monetary policy may have to be tightened somewhat.

I have never believed that slack is the main engine of inflation control.  I have talked about this a lot. If you take a standard Phillips Curve model, the inflation rate depends on a gap term, slack if you will, or resource utilization. {It also} depends on inflation expectations and a shock, or random term.  And I have often said that inflation expectations trump the gap.  So I put a high weight on inflation expectations. 

So what does the limited research on resource utilization and output gaps tell us? There are a few key, but preliminary findings from work done at the Bank for International Settlements...and some as yet unpublished work done by several of our Dallas Fed economists. Here are a few key points:
- The relationship between measures of domestic economic slack, such as industrial capacity utilization, and domestic inflation seems to have declined across a broad range of advanced countries in recent years.
- At the same time, proxies for global slack—such as unemployment rates and output gaps in a wide array of countries—seem to be of growing importance.
- And for some countries, including—and to my mind especially—the United States, the proxies for global slack have become more important predictors of changes in inflation than measures of domestic slack.