Friday, February 17, 2012

Flaws in CBO's output gap measure

Economists continue to be fixated on the supposedly massive output gap in the US economy as determined by the Bureau of Economic Analysis (BEA) and the Congressional Budget Office (CBO). This now-famous graph below has made rounds across multiple (sometimes politically motivated) publications, websites, and blogs. It speaks to an enormous output capacity built into the US economy that for one reason or another seems unachievable since the 08 crisis.

Source: Economic Policy Institute

This output gap, thought often taken for granted, may in fact be much smaller. Some recent work by Barclays Capital has already shown that the potential GDP (red line) is basically extrapolating the bubble of the pre-crisis era and is therefore unreliable.

The CBO number crunchers wish to believe in their ability to compute the potential GDP of the US economy.  The reality is that nobody knows how much output the US economy is truly capable of. But there are signs that the gap may now be below the CBO's assertion.

The folks at Capital Economics plotted the CBO estimated output gap against "inflation acceleration" - the difference between consecutive YOY core inflation measures. The argument is that if the economy is operating significantly below potential, inflation should have negative acceleration into a deflationary environment. However the two measures have diverged recently, indicating that the slack in the economy may not be that great.

Inflation Acceleration vs. CBO's output gap (Source: Capital Economics)

Another indicator of slack in the economy is the manufacturing capacity utilization. The average of this measure over the past 30 years is 79.5. The US manufacturing is now operating at 78.6 - rather close to the historical average. Clearly there is plenty of room for greater output, but we are not at capacity levels that show a massive under-utilization.

US manufacturing capacity utilization (Bloomberg)

Multiple curves can be drawn through this US GDP chart below, all supported by various analyses. But the recent evidence suggests that when it comes to output capacity, the US may be closer to the red line than to the yellow one.

US GDP, 2005 dollars (Bloomberg)

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