OUTPUT GAP UNCERTAINTY ANDREAL-TIME MONETARY POLICY

Francesco Grigoli, Alexander Herman, Andrew Swiston, and Gabriel Di Bella

International Monetary Fund

Rio de Janeiro, May 22, 2015

The views expressed in this presentation are those of the authors and should not be attributed to the IMF, its Executive Boards, or its management.

“What is it that no one can see, hear, smell, taste or touch, yet everyone knows is there? Answer: the output gap.“

–Caroline Baum, Bloomberg, April 12, 2010

F. Grigoli, A. Herman, A. Swiston, and G. Di Bella Output Gap Uncertainty and Real-Time Monetary Policy

Motivation

Measurement

Explaining Revisions

Monetary Policy Implications

Conclusions

F. Grigoli, A. Herman, A. Swiston, and G. Di Bella Output Gap Uncertainty and Real-Time Monetary Policy

F. Grigoli, A. Herman, A. Swiston, and G. Di Bella Output Gap Uncertainty and Real-Time Monetary Policy

-2.0

-1.5

-1.0

-0.5

0.0

0.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

2006 2007 2008 2009 2010 2011 2012

Sources: Congressional Budget Office; and IMF staff calculations.

Motivation Measurement Explaining Revisions Monetary Policy Implications Conclusions

CBO: Output Gap Estimates for 2004Percent of potential GDP

Output Gap: Important but Unpredictable

Wide range of uncertainty around the size of the output gap

Central banks do not rely solely on an estimate of the output gap in setting monetary policy, but it is a key input in policy decisions

Fundamental issue: distinguishing between trend and cycle

F. Grigoli, A. Herman, A. Swiston, and G. Di Bella Output Gap Uncertainty and Real-Time Monetary Policy

Motivation Measurement Explaining Revisions Monetary Policy Implications Conclusions

Sources of Revisions to Output Gap EstimatesFocus on data revisions and uncertainty over potential output

F. Grigoli, A. Herman, A. Swiston, and G. Di Bella Output Gap Uncertainty and Real-Time Monetary Policy

Motivation Measurement Explaining Revisions Monetary Policy Implications Conclusions

Vintage of estimate Descriptor Possible sources of deviations from final

t ForecastPolicy reactions, forecast error, data revisions, uncertainty over potential output

t + 1Initial estimate

Data revisions, uncertainty over potential output

t + 2 … t + 6Revised estimates

Data revisions, uncertainty over potential output

t + 7Final estimate

None, by definition

Initial Estimates and Revisions (Percent of potential GDP)"Excess capacity bias", 1/3 of the countries change sign

Number Percentof Median Standard Median Standard Median Standard switching

countries deviation deviation deviation signs

All countries 176 -0.97 5.12 -0.22 5.57 0.75 3.89 32.3Advanced 24 -0.24 1.61 0.27 2.49 0.51 1.67 22.9Emerging 122 -0.98 5.47 -0.34 5.90 0.64 4.11 32.7Low-income 30 -1.77 5.28 -0.22 5.93 1.55 4.16 38.8

Source: Authors' calculations.

Initial estimate Final estimate Revision

F. Grigoli, A. Herman, A. Swiston, and G. Di Bella Output Gap Uncertainty and Real-Time Monetary Policy

Motivation Measurement Explaining Revisions Monetary Policy Implications Conclusions

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

t+2 t+3 t+4 t+5 t+6 t+7

Median 75th percentile 90th percentile

Source: Authors' calculations.F. Grigoli, A. Herman, A. Swiston, and G. Di Bella Output Gap Uncertainty and Real-Time Monetary Policy

Motivation Measurement Explaining Revisions Monetary Policy Implications Conclusions

Marginal Output Gap Revisions by VintageAbsolute value; percent of potential GDP

F. Grigoli, A. Herman, A. Swiston, and G. Di Bella Output Gap Uncertainty and Real-Time Monetary Policy

Motivation Measurement Explaining Revisions Monetary Policy Implications Conclusions

Marginal Revisions to Potential and Real GDP GrowthAbsolute value; median

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

t+2 t+3 t+4 t+5 t+6 t+7

Potential growth Real GDP growth

Source: Authors' calculations.

Revisions to potential growth are larger than revisions to real growth

F. Grigoli, A. Herman, A. Swiston, and G. Di Bella Output Gap Uncertainty and Real-Time Monetary Policy

Motivation Measurement Explaining Revisions Monetary Policy Implications Conclusions

Cumulative Output Gap RevisionsInitial estimates less reliable when they are needed the most

0.0

1.0

2.0

3.0

4.0

5.0

6.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

All years Years with negative growth

All years Years with negative growth

Average absolute revision Standard deviation of revisions

Source: Authors' calculations.

Key findings about output gap estimates: Persistent uncertainty Excess capacity bias Less reliable in downturns

Robustness checks: Same results from desk-provided WEO and OECD

estimates, and CBO estimates for U.S. Changes to filtering methodology or sample period did

not affect results

F. Grigoli, A. Herman, A. Swiston, and G. Di Bella Output Gap Uncertainty and Real-Time Monetary Policy

What Did We Learn?

Motivation Measurement Explaining Revisions Monetary Policy Implications Conclusions

F. Grigoli, A. Herman, A. Swiston, and G. Di Bella Output Gap Uncertainty and Real-Time Monetary Policy

Motivation Measurement Explaining Revisions Monetary Policy Implications Conclusions

To Ease or To Tighten, That Is the QuestionOutput gap in percent of potential GDP

-8

-6

-4

-2

0

2

4

6

8

-8

-6

-4

-2

0

2

4

6

8

2008 2009 2010 2011 2012 2013

Brazil

-10

-8

-6

-4

-2

0

2

4

6

8

-10

-8

-6

-4

-2

0

2

4

6

8

2008 2009 2010 2011 2012 2013

Chile

-6

-4

-2

0

2

4

6

8

-6

-4

-2

0

2

4

6

8

2008 2009 2010 2011 2012 2013

Colombia

-12-10-8-6-4-20246810

-12-10-8-6-4-202468

10

2008 2009 2010 2011 2012 2013

Mexico

-8

-6

-4

-2

0

2

4

6

8

-8

-6

-4

-2

0

2

4

6

8

2008 2009 2010 2011 2012 2013

Peru

Sources: IMF, World Economic Outlook database; and authors' calculations.

Output gap (percent) +/- 1 Standard deviation +/- 2 Standard deviations

Are Output Gap Revisions Predictable Ex Ante?

What factors affect the size of revisions? Or, do the authorities have any role in reducing the size of the revisions?

What factors affect the probability of a change in the sign of the output gap? Or, do the authorities have any role in reducing the probability of wrongly gauging the cyclical position?

Pooled OLS and population-averaged probit for 171 countries over the period 1990-2007 (robustness with PCSE, logit, and WEO and OECD data)

F. Grigoli, A. Herman, A. Swiston, and G. Di Bella Output Gap Uncertainty and Real-Time Monetary Policy

Motivation Measurement Explaining Revisions Monetary Policy Implications Conclusions

Determinants of the Size of the Revisions

F. Grigoli, A. Herman, A. Swiston, and G. Di Bella Output Gap Uncertainty and Real-Time Monetary Policy

The goodness of fit ranges from 11 to 41 percent, suggesting that a large component of the revision cannot be predicted

Significant Not significant

Output gap size (+) Historical growth volatility

Domestic growth surprises (+) Inflation

World growth surprises (+) Cyclical fiscal rules

Resource dependence (+) GDDS

Inflation targeting (-) SDDS

OECD (-) Conflicts

LIC (+) Governance variables

Small economies (+)

Motivation Measurement Explaining Revisions Monetary Policy Implications Conclusions

Probability of a Sign Change in the Output Gap

F. Grigoli, A. Herman, A. Swiston, and G. Di Bella Output Gap Uncertainty and Real-Time Monetary Policy

Significant Not significant

Output gap size (-) Small economies

Domestic growth surprises (+) GDDS

Inflation (+) Conflicts

Inflation targeting (-) Governance variables

Cyclical fiscal rules (+)

OECD (-)

LIC (+)

SDDS (-)

Motivation Measurement Explaining Revisions Monetary Policy Implications Conclusions

Initial and Final Estimates of the Output GapMoving to quarterly data, in percent of potential GDP

F. Grigoli, A. Herman, A. Swiston, and G. Di Bella Output Gap Uncertainty and Real-Time Monetary Policy

Motivation Measurement Explaining Revisions Monetary Policy Implications Conclusions

Sources: National authorities; and authors' calculations.

-5

-4

-3

-2

-1

0

1

2

3

4

5

-5

-4

-3

-2

-1

0

1

2

3

4

5

2005 2007 2009 2011 2013

Brazil

-5

-4

-3

-2

-1

0

1

2

3

4

5

-5

-4

-3

-2

-1

0

1

2

3

4

5

2005 2007 2009 2011 2013

Chile

-3

-2

-1

0

1

2

3

4

-3

-2

-1

0

1

2

3

4

2005 2007 2009 2011 2013

Colombia

-8

-6

-4

-2

0

2

4

-8

-6

-4

-2

0

2

4

2005 2007 2009 2011 2013

Mexico

-3

-2

-1

0

1

2

3

4

5

6

-3

-2

-1

0

1

2

3

4

5

6

2005 2007 2009 2011 2013

PeruPeru

Initial estimate Latest estimate

Policy Deviations Due to Output Gap RevisionsActual interest rate minus revised prescription from reaction function, p.p.

F. Grigoli, A. Herman, A. Swiston, and G. Di Bella Output Gap Uncertainty and Real-Time Monetary Policy

-5-4-3-2-1012345

-5-4-3-2-1012345

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Brazil

-4

-3

-2

-1

0

1

2

3

-4

-3

-2

-1

0

1

2

3

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Chile

-3

-2

-1

0

1

2

3

-3

-2

-1

0

1

2

3

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Colombia

-3

-2

-1

0

1

2

3

-3

-2

-1

0

1

2

3

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Mexico

-3

-2

-1

0

1

2

3

4

5

-3

-2

-1

0

1

2

3

4

5

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Peru

Source: Authors' calculations.

Motivation Measurement Explaining Revisions Monetary Policy Implications Conclusions

Output Gap Revisions and InflationAre they correlated?

F. Grigoli, A. Herman, A. Swiston, and G. Di Bella Output Gap Uncertainty and Real-Time Monetary Policy

F-statistic (Wald, for use with HAC robust SE)

Lags 0-4 Lags1-4 Lags 0-4 Lags1-4 Lags 0-4 Lags1-4 Lags 0-4 Lags1-4

Brazil ** ** *Chile ** ** ** **Colombia ** ** ** ** ** ** ** *Mexico * ** ** ** **Peru ** ** ** **

Notes: ** denotes statistically significant at the 5 percent level; * denotes statistically significant at the 10 percent level.

Shaded cells denote statistically significant relationships of the wrong sign.

Source: Authors' calculations.

Initial estimate of the output gap Revision to output gapHeadline Core Headline Core

Motivation Measurement Explaining Revisions Monetary Policy Implications Conclusions

Concluding RemarksTake aways

F. Grigoli, A. Herman, A. Swiston, and G. Di Bella Output Gap Uncertainty and Real-Time Monetary Policy

Low reliability of initial assessments of excess capacity

Share of output gap revisions that can be explained ex ante is low

For LA-5 ITers, policy made in real time deviates from ideal policy estimated ex post

This explains a large share of inflation deviations from target

Efforts are required to improve real-time assessment of excess capacity

Motivation Measurement Explaining Revisions Monetary Policy Implications Conclusions

OUTPUT GAP UNCERTAINTY ANDREAL-TIME MONETARY POLICY

Francesco Grigoli, Alexander Herman, Andrew Swiston, and Gabriel Di Bella

International Monetary Fund

Rio de Janeiro, May 22, 2015

The views expressed in this presentation are those of the authors and should not be attributed to the IMF, its Executive Boards, or its management.