America's Output Gap

In one of Janet Yellen's recent semi-annual testimonies before the House Financial Services Committee, she was asked about her estimate of the existing output gap.  Before I give her response, let's look at what an "output gap" is and what it means to the economy.

According to the definition used by the IMF, the output gap is:

"...an economic measure of the difference between the actual output of an economy and its potential output. Potential output is the maximum amount of goods and services an economy can turn out when it is most efficient—that is, at full capacity. Often, potential output is referred to as the production capacity of the economy.­"

A positive output gap occurs when actual output is higher than full-capacity output.  This occurs when demand is very high and to meet that demand, workers and factories operate above their most efficient capacity to meet the needs of the economy.  A negative output gap occurs when actual output is less than what an economy could produce at full capacity.  Weak demand creates a situation where there is spare capacity or slack in the economy.  In this case, GDP is below its potential level and the economy is under-performing.   When an economy has a significant negative output gap, it results in less than full employment and has "immediate implications for monetary policy" according to the IMF.

Let's look at a graph that shows the output gap for the United States from 1980 to 2018 from Economy Watch, keeping in mind that the data for the period between 2015 and 2018 are estimates:

The output gap during and since the Great Recession began in 2008 has been the longest and deepest period of negative output gap since 1980.  The negative output gap peaked at -6.718 percent in 2009, the deepest level in nearly thirty years.  In 2014, the output gap was -3.532 percent and is projected to be -2.584 percent in 2015.   Projections also suggest that the output gap will remain negative until 2018.

This is the end result of the long period of a negative output gap:

By 2013, the economic output of the United States was $868 billion (in 2005 chained dollars) below its potential because of the output gap.

Now, let's compare the output gap in the United States (in red) to Canada (in green), Germany (in blue) and Australia (in purple):

You will notice that the output gap since the Great Recession has been quite different for each of the four nations.  While Australia (in purple) barely saw a negative output gap, both Germany (in blue) and Canada (in green) saw their output gaps spike to -3.838 and -3.47 percent respectively, about half the output gap in the United States.  In both cases, unlike the United States, within two years, the output gaps of both Germany and Canada had returned to a more normal level of 0.607 percent for Germany and -1.385 percent for Canada compared to -4.941 percent for the United States.  Obviously, the economies in Germany, Canada and Australia were  (and are still) functioning much closer to capacity more quickly than in the United States.

Accuracy in the calculation of output gap can be difficult.  With that in mind, Ms. Yellen's suggestion that her "back of the envelope" guestimate of a little over negative 2 percent is likely way off the mark.  Returning to the pre-Great Recessionary economic growth trajectory has proven to be problematic, leaving the size of the economy at least a trillion dollars smaller than it would normally have been had pre-2008 growth rates continued. The persistent negative output gap suggests that the Federal Reserve's monetary policies, although unprecedented in scope, have been unable to meaningfully resuscitate the economy and goes a long way to explaining why inflation has remained relatively tame and the real recovery in employment has been modest.  But I can almost guarantee that you'll never hear that from any central banker.