The recent run of strong growth in GDP is welcome news, but from the perspective of policymakers there are signs that the economy may be approaching its maximum output capacity. In turn, this analysis provides the Federal Reserve with another reason to continue squeezing monetary policy.
Comparing the ratio of reported GDP for the third quarter to potential GDP shows that the economy has not only recovered from the Great Recession in 2008-2009 at the headline level but is now running at well above capacity – the theoretical maximum output. Although estimating how hot the economy can run is as much art as it is science, it’s striking to note the extent of the rebound in one estimate of the so-called output gap in recent years.
The datasets used to calculate the ratio: the standard real GDP numbers published by the Bureau of Economic Analysis and CBO’s periodic estimates of potential real GDP. As the chart below shows, this ratio is above 1.06, which exceeds the previous peak that arrived just ahead of the last recession. In other words, the economy appears to be running hot relative its theoretical output ceiling.
The second chart shows the same numbers as distinct data series. It’s clear that real GDP (blue line) has pulled further ahead of potential real GDP (red line) in recent years. By comparison, during the last recession real GDP was running well below potential real GDP – a deficit that strongly implied that a hefty dose of monetary stimulus was needed at the time to juice economic activity.
The logic here is that the economy has a theoretical ceiling. Actual output can surpass its theoretical maximum for a period of time – a positive output gap, which is the prevailing condition of late. Eventually, however, the natural limits for an economy running at or near full speed acts as a brake on growth. In those periods when actual GDP exceeds potential GDP, the risk of a cyclical slowdown is relatively high if trouble arises in the form of an economic shock.
Although the ratio of real to potential GDP looks comparatively high at the moment, it’s not obvious that it can’t go higher or remain at the current level for an extended period. In other words, we should be cautious in using this data for short-term estimates of recession risk. For that type of analysis, we should look to other analytical frameworks, such as the periodic business-cycle profiles that are published by The Capital Spectator and the weekly updates from The US Business Cycle Risk Report.
As for the rise in GDP-to-potential-GDP ratio, the data is telling us that there’s no slack left in the economy. The trend will likely be a factor in the Fed’s analysis for monetary policy. As a St. Louis Fed research note put it several years ago, “Potential GDP is important because monetary policymakers use the difference between actual and potential GDP—the output gap—to determine whether the economy needs more or less monetary stimulus.”
By that standard, the central bank looks set to extend its hawkish bias for the near term.
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