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The Challenges of Estimating Potential Output in Real Time

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The Challenges of Estimating Potential Output in Real Time The Challenges of Estimating Potential Output in Real Time Robert W. Arnold Potential output is an estimate of the level of gross domestic product attainable when the economy is operating at a high rate of resource use. A summary measure of the economy’s productive capacity, potential output plays an important role in the Congressional Budget Office (CBO)’s economic forecast and projection. The author briefly describes the method the CBO uses to estimate and project potential output, outlines some of the advantages and disadvantages of that approach, and describes some of the challenges associated with estimating and projecting potential output. Chief among these is the difficulty of estimating the underlying trends in economic data series that are volatile, subject to structural change, and frequently revised. Those challenges are illustrated using examples based on recent experience with labor force growth, the Phillips curve, and labor produc- tivity growth. (JEL E17, E32, E62) Federal Reserve Bank of St. Louis Review, July/August 2009, 91(4), pp. 271-90. ssessing current economic conditions, falls below potential, then resources are lying gauging inflationary pressures, and idle and inflation tends to fall. projecting long-term economic growth In addition to being a measure of aggregate are central aspects of the Congressional supply in the economy, potential output is also BudgetA Office (CBO)’s economic forecasts and an estimate of trend GDP. The long-term trend in baseline pro jections. Those tasks require a sum- real GDP is generally upward as more resources— mary measure of the economy’s productive capac- primarily labor and capital—become available and ity. That measure, known as potential output, is technological change allows more productive an estimate of “full-employment” gross domestic use of existing resources. Real GDP also displays short-term variation around that long-run trend, product (GDP)—the level of GDP attainable when influenced primarily by the business cycle but the economy is operating at a high rate of resource also by random shocks whose sources are difficult use. Although it is a measure of the productive to pinpoint. Analysts often want to estimate the capacity of the economy, potential output is not underlying trend, or general momentum, in GDP a technical ceiling on output that cannot be by removing short-term variation from it. A dis- exceeded. Rather, it is a measure of sustainable tinct, but related, objective is to remove the fluc- output, where the intensity of resource use is tuations that arise solely from the effects of the neither adding to nor subtracting from short-run business cycle. inflationary pressure. If actual output exceeds Potential output plays a role in several areas its potential level, then constraints on capacity associated with the CBO’s economic forecast. In begin to bind, restraining further growth and particular, we use potential output to set the contributing to inflationary pressure. If output level of real GDP in its medium-term (or 10-year) Robert W. Arnold is principal analyst in the Congressional Budget Office. © 2009, The Federal Reserve Bank of St. Louis. The views expressed in this article are those of the author(s) and do not necessarily reflect the views of the Federal Reserve System, the Board of Governors, or the regional Federal Reserve Banks. Articles may be reprinted, reproduced, published, distributed, displayed, and transmitted in their entirety if copyright notice, author name(s), and full citation are included. Abstracts, synopses, and other derivative works may be made only with prior written permission of the Federal Reserve Bank of St. Louis. FEDERALRESERVEBANKOFST. LOUIS REVIEW JULY/AUGUST 2009 271 Arnold projections. In doing so, we assume that the gap series that is attributable solely to business cycle between GDP and potential GDP will equal zero fluctuations. Ideally, the resulting series will on average in the medium term. Therefore, the reflect not only the trend in the series, but also CBO projects that any gap that remains at the end will be benchmarked to some measure of capacity of the short-term (or two-year) forecast will close in the economy and, therefore, can be interpreted during the following eight years. We also use the as the potential level of the series. level of potential output as one gauge of inflation- For most variables in the model, we use a ary pressures in the near term. For example, an cyclic-adjustment equation that combines a rela- increase in inflation that occurs when real GDP is tionship based on Okun’s law with linear time below potential (and monetary growth is moder- trends to produce potential values for the factor ate) can probably be attributed to temporary fac- inputs. Okun (1970) postulated an inverse rela- tors and is unlikely to persist. Finally, potential tionship between the size of the output gap (the output is an important input in computing the percentage difference between GDP and potential standardized-budget surplus or deficit, which the GDP) and the size of the unemployment gap (the CBO uses to evaluate the stance of fiscal policy difference between the unemployment rate and and reports regularly as part of its mandate. the “natural” rate of unemployment). According to that relationship, actual output exceeds its potential level when the unemployment rate is THE CBO METHOD FOR below the natural rate of unemployment and falls ESTIMATING POTENTIAL OUTPUT short of potential output when the unemployment rate is above its natural rate (Figure 1). The CBO model for estimating potential out- For the natural rate of unemployment, we use put is based on the framework of a neoclassical, the CBO estimate of the non-accelerating inflation or Solow, growth model. The model includes a Cobb-Douglas production function for the non- rate of unemployment (NAIRU). That rate corre- farm business (NFB) sector with two factor inputs, sponds to a particular notion of full employment— labor (measured as hours worked) and capital the rate of unemployment that is consistent with (measured as an index of capital services pro- a stable rate of inflation. The historical estimate vided by the physical capital stock), and total of the NAIRU derives from an estimated relation- factor productivit y (TFP), which is calculated as ship known as a Phillips curve, which connects a residual. NFB is by far the largest sector in the the change in inflation to the unemployment rate economy, accounting for 76 percent of GDP in and other variables, including changes in produc- 2007, compared with less than 10 percent for each tivity trends, oil price shocks, and wage and price of the other sectors. For smaller sectors of the controls. The historical relationship between the economy, including farms, federal government, unemployment gap and the change in the rate of state and local government, households, and non- inflation appears to have weakened since the mid- profit institutions, simpler equations are used to 1980s.2 However, a negative correlation still exists; model output. Those equations generally relate when the unemployment rate is below the NAIRU, the growth of output in a sector to the growth of inflation tends to rise, and when it exceeds the the factor input—either capital or labor—that is NAIRU, inflation tends to fall. Consequently, the more important for production in that sector.1 NAIRU, while it is less useful for inflation fore- To compute historical values for potential out- casts, is still useful as a benchmark for potential put, we cyclically adjust the factor inputs and output. then combine them using the production function. The assumption of linear time trends in the Cyclical adjustment removes the variation in a cyclic-adjustment equation implies that the poten- 1 This section gives an overview of the CBO method. For a more 2 For a description of the procedure used to estimate the NAIRU, complete description, see CBO (2001). see Arnold (2008). 272 JULY/AUGUST 2009 FEDERALRESERVEBANKOFST. LOUIS REVIEW Arnold Figure 1 Okun’s Law: The Output Gap and the Unemployment Gap Percent 10 5 4 3 5 2 1 0 0 –1 –2 –5 Output Gap (left scale) –3 Unemployment Gap (inverted, right scale) –4 –10 –5 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 NOTE: Gray bars in Figures 1, 2, 3, 5, 6, and 8 indicate recession as determined by the National Bureau of Economic Research. tial version of each variable grows at a constant Ti = zero until the business-cycle peak rate during each historical business cycle. Rather occurring in year i, after which it equals than constraining the potential series to follow a the number of quarters elapsed since that single time trend throughout the entire sample, peak. the model allows for several time trends, each Equation (1), a piecewise linear regression, beginning at the peak of a business cycle. Defining is estimated using quarterly data and ordinary the intervals of the time trends using full business least squares. Potential values for the series being cycles helps to ensure that the trends are estimated adjusted are calculated as the fitted values from consistently throughout the historical sample. the regression, with U constrained to equal U *. Most economic variables have distinct cyclical Setting the unemployment rate to equal the NAIRU patterns—they behave differently at different removes the estimated effects of fluctuations in points in the business cycle. Specifying break- the business cycle; the resulting estimate gives points for the trends that occur at different stages the equation’s prediction of what the dependent of different business cycles (say, from trough to variable (X) would be if the unemployment rate peak) would likely provide a misleading view of never deviated from the NAIRU. An example of the underlying trend. the results of using the cyclic-adjustment equa- The cyclic-adjustment equation has the follow- tion is illustrated in Figure 2, which shows TFP ing form: and potential TFP.
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