I am not a fan of “output gaps”, this measure of how much are resources in the economy employed. But central banks all over the world use it and thus we have to at least mention it.
In theory an output gap shows how far is the economy from its potential. A positive gap means that current GDP is above its long term potential while a negative one shows that the opposite.
Here is how central banks use this measure. If for example we are looking at a positive output gap (potential GDP minus current GDP) then the central bank will use this to say that it needs to increase interest rates. If the central bank forecasts a positive output gap for the period ahead than we should expect more interest rate rises until the forecast of the output gap is zero or slightly negative.
Let’s take now the case for the Romanian economy. In February 2009, the NBR was estimating that output gap will reach its worst at -2% sometime that year but then it will be back to potential by middle of 2010. If they were talking about the potential before the crisis than it would have meant full recovery of nominal GDP to the pre-crisis level in just one year. Furthermore, such an estimate of the output gap would have not required a series of interest rate cuts as all resources in the economy would have been fully employed again quite soon.
As we know today it did not happen that way. In fact the output gap estimates in February 2010 show that the minimum was much lower, at -7.5%, and now the return to potential should have been expected sometime during 2012. With this estimate of the output gap one would should have expected a long period of relaxed monetary policy. That was not the case, but on this one on a later post.
A year later on February 2011 the output gap estimates show that recovery to full potential is now pushed to 2013. Thus, fiscal and monetary policies did not have a positive effect on recovery to potential GDP which meant that capital and labor will still be under-employed until at least 2013.
It is now one more year later, February 2012, and the story repeats itself and now the NBR expects return to potential GDP in the later part of 2016 or later.
Here is a graph showing all these estimates.
As you can see there is an evolution also. While the output gap remains negative the level gets smaller. The difference relative to potential GDP has lowered from -7.5% to -4%. Isn’t that a good thing you might ask? Isn’t that showing that fiscal and monetary policies have worked and it just takes a little more time but we are on the right track?
No and this is why. If the output gap would have been calculated against the potential GDP from 2008 then yes the smaller output gap, albeit negative, would have shown progress. Unfortunately both my estimates and official estimates show that potential GDP is much lower than in 2008. In my view close to zero but by official estimates around 2.5%. Therefore, the output gap was not closed by the lower bound, good economic performance, but by the upper bound which shows loss of potential GDP. In other words Romania will catch up to the average EU country in much longer period if we keep the current mix of economic policies.
It is clear, at least to me, that the current mix of fiscal and monetary policy are not helping the economy move to full employment. Even worse, it seems that the long term potential GDP has been at best halved relative to its 2008 level. To restore potential GDP and speed-up the closing of the output gap Romanian economic policies need to “relax”. So far, as the output gap shows both fiscal and monetary policy have been too tight. To be more specific, fiscal policy needs to lower taxes and monetary policy needs to create a liquid long term money market (not necessarily lower interest rates).