Separating the trend from the cycle: The debate on euro area potential output and implications for monetary policy

Article published in the Economic Review of September 2019: available articles

International institutions like the IMF, OECD and the European Commission estimate that the euro area economy is operating at full capacity. In other words, the negative output gap that had appeared just after the economic and financial crisis has (almost) closed. Yet, some are casting doubt on this claim. And that is hardly surprising because an economy’s potential cannot be measured accurately and it is therefore surrounded by great uncertainty. The debate specifically focuses on the fact that if the output gap has narrowed, it is largely because the economic potential has been revised downwards.

Research reveals that the estimates of potential GDP published by many international institutions overreact to demand shocks (such as adjustments to monetary or fiscal policy) and underreact to supply shocks (like total factor productivity). As a result, potential GDP frequently moves in tandem with the economic cycle: when the economy is performing poorly, the estimate of potential output is often revised downwards too. When the economy recovers, potential GDP generally tends to be revised upwards. In view of these observations, it may be worth looking into the means of softening the procyclical nature of potential GDP. This article suggests some possible avenues to explore.

However, economic theory is not at all clear as to which shocks should influence potential GDP or the supply side of the economy. Of course, permanent supply shocks, like demographics, are key factors of an economy’s productive capacity. But there is also the question of whether demand shocks affect the supply side too. If aggregate demand remains weak for a long time, the economy’s potential may well also come under pressure, for instance because the long-term unemployed lose their skills or firms put an end to innovative business activities. This is called hysteresis and has implications for monetary policy. More generally speaking, these observations put into question the assumption that monetary policy is neutral in the longer term with regard to real variables, like growth and employment.

Given the empirical and theoretical uncertainty surrounding the concept of potential GDP, it would seem prudent for monetary policy-makers to look at a broad number of variables when assessing the temperature of the economy.