Monetary Policy and the Output Gap

Significant attention has been paid to when the Federal Open Market Committee (FOMC) will elect to raise interest rates, with the FOMC indicating that the target federal funds rate may stay below its longer-run normal level if economic conditions warrant, even after employment and inflation are near mandate-consistent levels. However, the way those conditions are measured may play an important role in determining when interest rates should go up, according to a recent Economic Synopses essay from the St. Louis Fed.

Senior Economist Fernando Martin examined the Taylor rule, which describes the federal funds rate as a function of how far inflation and output are from their desired values. The Taylor rule is expressed as follows:

i_t = i* + 1.5(π_t – π*) + 0.5(y_t – y_t*)

In this equation, i_t is the FOMC’s operating target for the federal funds rate; π_t and π* are the actual and targeted inflation rates, respectively; y_t and y_t* are actual and potential output, respectively (with the difference being the output gap); and i* is the federal funds rate consistent with on-target inflation and output.

Since late 2008, the Taylor rule has prescribed a zero nominal interest rate. As inflation has been close to its 2 percent annual target, the prescription has been due to the large negative output gap, which Martin measured as 15 percent below its 1955-2007 trend as of the third quarter of 2014. In fact, Martin noted that the output gap would need to be reduced by half before the Taylor rule would start prescribing a positive interest rate.

However, the output gap was measured using real GDP per capita. When measured as real GDP per labor force participant to account for the declining labor force participation rate, output was only 2 percent below its prerecession trend as of the third quarter of 2014. Had this measure been used for the output gap, the Taylor rule would have prescribed a positive interest rate since early 2010 and would currently call for the federal funds rate to be around 2 percent annually.

Martin concluded, “This exercise suggests that the debate about monetary policy should revolve around how to measure potential output. Overestimating how far the economy is from its potential unnecessarily risks delaying the end of unusual monetary accommodation and the return to a historically more normal policy stance.”

Additional Resources

• Economic Synopses: Monetary Policy and the Output Gap
• On the Economy: Projecting GDP Growth Using Labor Force Participation Trends
• On the Economy: Are Wages and the Unemployment Rate Correlated?