This is about potential real output. In March 2012 I posted “Another ‘bitch’: potential output” and concluded:
And the next chart gives up a “red light” indicating the possibility of “structural” problems being “brewed” by the complete absence of “cojones” (stronger Spanish word for “balls”) being shown by the Fed/FOMC!
The updated version of the chart follows:
Now, David Altig of the Atlanta Fed shows this chart
The potential GDP line in that chart is the level of production that represents the structural path of the economy. Forecasters, no matter where they think that potential GDP line might be, all believe actual GDP will eventually move back to it. “Output gaps”—the shaded area representing the cumulative miss of actual GDP relative to its potential—simply won’t last forever. And if that means GDP growth has to accelerate in the future (as it does when GDP today is below its potential)—well, that’s just the way it is.
Unfortunately, potential GDP is not so simple to divine. We have to guess (or, more generously, estimate) what it is. That guessing game has been harder than usual over the past several years. Here is the record of the CBO’s potential GDP since 2010 (I show it including the actual course of RGDP):
This much, in any event, is clear: Given any starting point where the level of GDP is below its potential level—that is, given an output gap—forecasts will include a bounce back in GDP growth above its long-run average, at least for a while. That’s just the way it works.
If, contrary to conventional wisdom, you believe that the true output gaps are much smaller than suggested in the CBO picture above, you might want to take the under on a bet to whether GDP forecasts will prove too optimistic once again.
God almighty, we´re down to ‘betting games’! It appears to be ‘God-given’ that how fast the economy grows (the ‘bounce-back’) depends on how far below ‘potential’ it is. Your job is to ‘guesstimate’ the ‘true potential’. The one who ‘guesstimates’ best will ‘win the pot’! Monetary policy has nothing (or not much) to do with that.
Let´s imagine that spending is a major driver of economic activity and also that the Fed has close control of spending. Imagine also that price/wages are sticky. What happens when, for some (sick?) reason the Fed allows nominal spending (NGDP) to take a plunge? Given stickiness of prices and wages it is a ‘sure thing’ that real output (RGDP) will also tumble. The crash in real output will make unemployment to soar/employment to tank.
Will the economy ‘spontaneously’ bounce back and do it at a rate that is in some sense proportional to the ‘gap’ that opened up? Or does the economy need to be ‘stimulated’?
The chart below shows NGDP relative to the “Great Moderation” trend level path.
The next chart shows RGDP relative to the latest CBO estimate of ‘potential output’.
What they show is that the economy is acting like a ‘mole’, digging an inclined hole underneath any reasonable level trend that could be imagined. Variables like employment show conformable behavior.
What if, instead of resources being devoted to constantly more around the ‘goalpost’ – ‘potential output’ – the FOMC experienced an ‘epiphany’?
Unlikely. Note that inflation is right where the Fed wants it. That´s all that matters!