The fall in potential output and the uncertainty around the degree of its decline (see Chapter 2) add to an already challenging policy environment, even though the concept of potential output varies slightly with the policy goal. For monetary policy, the relevant concept is the economy’s output at full capacity, taking into account fluctuations in productivity.17 In the medium and longer term, these fluctuations play a smaller role, and the relevant concept becomes full capacity output in the long run. The impact of the crisis, however, is likely to be large enough to dominate in either case and will thus create decision problems for monetary and fiscal policymakers alike. On the one hand, for instance, if fiscal policy neglects or underestimates the decline, it could put the sustainability of public finances at risk. On the other hand, overestimating the drop in potential might mean withholding needed fiscal support from the economy. Similarly, if monetary policy overestimates the decline in potential output in the short run, it risks being overly restrictive, while underestimating the drop in potential might lead to an overly permissive policy stance and open the door to inflationary pressures (OECD, 2008). In addition, these uncertainties could allow policymakers and the public to draw different conclusions about the direction of potential output, further complicating policy choices.
The uncertainty surrounding potential output has important implications for macroeconomic policy as well. In dealing with this uncertainty, central banks will profit from reinforcing their commitment to price stability to anchor expectations as well as to limit the costs of possible policy mistakes as they maneuver past the trough of the crisis. Fiscal policy will be well advised to err on the side of caution and plan for a sizable and early adjustment to regain the fiscal space lost to the crisis. And both fiscal and monetary policymakers will benefit from being transparent in communicating their views about the potential output and the output gap and the way these views inform their policy decisions.
Crisis Impact on Monetary Policy
While information on potential output is an important ingredient in monetary policy decisions, it is also notoriously hard to pin down with great accuracy. Most conventional macroeconomic models associate an increase in actual output relative to potential output (that is, an increase in the output gap, the percentage deviation of the actual level of output from its potential) with higher inflation and vice versa.18 The underlying argument is that price-setting firms tend to increase prices in line with marginal costs and, by extension, the output gap. Because many firms operate in a forward-looking manner, inflation reflects their current and future beliefs about the output gap. Consequently, central banks spend considerable time trying to produce reliable estimates and forecasts of the output gap to inform their monetary policy decisions. By accounts of monetary policy practitioners and academics alike, though, this task has proved difficult.19 Estimates of present or future output gaps are bedeviled by limits to data availability in real time, large data revisions, the general imponderability of forecasting, and conceptual problems, including the fact that the output gap at the same time influences the economy and is influenced by it.
Dealing with Uncertainty
The uncertainty around estimates of the real-time output gap is high and has likely increased significantly as a result of the crisis.20 A comparison of simple filter-based quasi “real-time” estimates of the output gap in the euro area to the actual or “true” gap computed with the advantage of hindsight over a longer period provides a clear illustration (Figure 14).21 The real-time estimate is based only on data that could have been available to policymakers at the time, ignoring data revisions. By construction, the estimated real-time gaps will be less accurate, especially around turning points of the true series, which the real-time approach will often miss.22
Euro Area: “Real-Time” and “True” Output Gaps, 1993:Q1–2007:Q2
(Percent)
Source: IMF staff estimates.This example shows that the real-time judgment includes a sizable and quite persistent error (for example, the unconditional standard deviation of the error is almost 1 percentage point and its autoregressive coefficient is about 0.9). Moreover, because at times the real-time output gap takes the opposite sign of the true gap, it could potentially lead policymakers to mistake the direction of price pressures. Against this background, especially given the ambiguity about the impact of the crisis on financial intermediation, the heightened uncertainty over recent estimates of the output gap and forecasts is hardly surprising (see Chapter 2).
Policymakers thus face a difficult task—separating the information contained in measures of potential output from the noise surrounding it. In practice, a central bank looks at a wide array of economic and monetary indicators, cross-checking the information where possible (see, for example, ECB, 2004; and Fischer and others, 2008). Including measures of the output gap could add crucial information on existing and future threats to price stability; at the same time, the information can be imprecise or misleading. In addition, that uncertainty can lead to diverging views on the state of the economy. For instance, if the views of the central bank and those of the general public are not in accord, such differences could drive an informational wedge between price setters and policymakers (Gorodnichenko and Shapiro, 2007).23 Although this discussion is ongoing, many observers agree that the output gap should inform monetary policymaking even in the presence of exceptional uncertainty. For example, Orphanides and others (2000) using data on historical revisions to real-time estimates of the output gap in the United States, show that it is usually optimal to place some weight on the output gap when decisions on the course of monetary policy are being made, even in the presence of measurement error. Ehrmann and Smets (2003) come to a similar conclusion based on a calibrated model of the euro area with incomplete information about potential output.24
Simulations with a standard macroeconomic model fitted to euro area data illustrate that it is costly for policymakers to ignore the output gap, even in the face of uncertainty.25 In the simulation, monetary policy is assumed to set interest rates conditional on inflation and the output gap, but owing to potential uncertainty over output, the perception of the private sector of the actual size of the output gap can temporarily deviate from that of the central bank (Table 6).26 Reinforcing the findings discussed above, the economy appears to be better off if monetary policy reacts to the output gap than if it does not—judged by the higher volatility of inflation and the output gap to shocks to interest rates, inflation, or the output gap, when the output gap is not taken into account.
Macroeconomic Performance Under Output Gap Uncertainty
(Standard deviation, percentage points)
Macroeconomic Performance Under Output Gap Uncertainty
(Standard deviation, percentage points)
| 50 Basis Points Shock to: | ||||||
|---|---|---|---|---|---|---|
| Interest rates | Inflation | Output gap | ||||
| Policymakers: | ||||||
| React to output gap |
Ignore output gap |
React to output gap |
Ignore output gap |
React to output gap |
Ignore output gap |
|
| Inflation | 0.09 | 0.12 | 0.10 | 0.11 | 0.29 | 0.33 |
| Output | 0.14 | 0.17 | 0.05 | 0.06 | 0.41 | 0.43 |
Macroeconomic Performance Under Output Gap Uncertainty
(Standard deviation, percentage points)
| 50 Basis Points Shock to: | ||||||
|---|---|---|---|---|---|---|
| Interest rates | Inflation | Output gap | ||||
| Policymakers: | ||||||
| React to output gap |
Ignore output gap |
React to output gap |
Ignore output gap |
React to output gap |
Ignore output gap |
|
| Inflation | 0.09 | 0.12 | 0.10 | 0.11 | 0.29 | 0.33 |
| Output | 0.14 | 0.17 | 0.05 | 0.06 | 0.41 | 0.43 |
That said, reacting to an uncertain drop in potential output under current circumstances remains risky, and the likelihood of a costly policy mistake is significant. If, for some reason, monetary policymakers were overly optimistic about potential output, they would tend to overestimate the output gap (that is, to see actual output further below potential than it actually would be) and set interest rates too low compared to what they would do if they knew the path of potential output with certainty. Conversely, interest rates would be set too high if potential output were viewed too pessimistically and the output gap underestimated. A simulation with the model for the euro area is illustrative: when the central bank underestimates the output gap by 0.5 percentage point relative to the public’s view, monetary policy is tighter, and interest rates are higher by about 150 basis points over a year, while inflation is lower by 0.7 percentage point.
Anchoring Expectations
If reacting to the available information on potential output remains optimal even under uncertainty and policy mistakes cannot be avoided per se, the key question becomes how to minimize their costs.
One way is for central banks to communicate forcefully their commitment to maintaining price stability in the context of the current uncertainty. Indeed, “price stability” is the primary goal of most European monetary policymakers, including, for example, the European Central Bank (ECB), the Bank of England (BoE), Sweden’s Riksbank (RB), and Narodowy Bank Polski (NBP), the Polish central bank. For policy purposes, while all interpret price stability as maintaining a specific rate of inflation, they differ in the degree to which they are ready to tolerate deviations from the target. The NBP and the RB allow inflation fluctuations within a +1/–1 percentage point band around their target values. In the case of the BoE, if the target is missed by more than 1 percentage point on either side, the governor must write an open letter to the chancellor explaining the reasons for the deviation and how the bank will ensure that inflation returns to the target within a reasonable time period without creating undue instability in the economy. And the ECB, while not having a formal band, is committed to keeping inflation “just below but close to 2 percent” over the medium term.
Under the present circumstances, reinforcing the central bank’s commitment to price stability (focusing specifically on the repercussions of uncertainty about the output gap on inflation) would help anchor inflation expectations more firmly and more closely align the beliefs of the central bank and those of the public about the actual output gap (Gorodnichenko and Shapiro, 2007).
In practice, this approach would require a specific communication effort, implying, in particular, that the central bank make transparent its views on the development of potential output upon which it is basing current monetary policy decisions and announce clearly its willingness to adjust these views in light of new information and to act upon it to ensure price stability.27 An effort along these lines would seem especially helpful in transitioning from the current policy stance of very low interest rates while avoiding unwittingly creating deflationary expectations.28
A simulation exercise for the euro area illustrates the argument (Figure 15). Following an adverse shock to the output gap, the public is assumed to believe that the gap has declined by more than the central bank does. The simulation results show that the central bank will need to decrease interest rates by less while securing lower rates of disinflation and can reverse its course sooner when it is more strongly committed to maintaining price stability by explicitly signaling its willingness to adjust course as new information accrues. The reason for this outcome is that forward-looking price setters will limit any downward price revisions anticipating that differences in views on the development of the output gap will eventually be resolved and price stability achieved.
The Benefits of a Price Stability Commitment Under Output Gap Uncertainty
(50 basis points output gap shock; deviation from baseline; percentage points)
Time period (quarters)Implications for Monetary Policy
Most of Europe’s monetary policymakers have reacted to the financial turmoil and the ensuing recession by bringing the policy rates to record lows (Figure 16) and by deploying various unconventional measures (see Chapter 1). This reaction reflects, in part, the conviction that, while the crisis has diminished potential output across the region, actual output has declined even faster, opening up a sizeable and lasting output gap and resulting in strong disinflationary pressures. As conditions in the financial system normalize and recovery takes hold, monetary policy will need to gradually turn less expansionary and eventually become restrictive to safeguard price stability.
Selected European Countries: Policy Rates, 2007–09
(Percent)
Sources: Haver Analytics; European Central Bank; Bank of England; Sveriges Riksbank; and National Bank of Poland.The speed of this adjustment will, among other considerations, depend on central banks’ views on the—uncertain—path of potential output. Other things being equal, interest rates should increase faster if there is reason to believe that the crisis has significantly reduced potential output. Monetary policymakers thus face the problem illustrated above: gauging the impact of the crisis remains difficult, but ignoring the possibility of changes to potential output could be costly.
To mitigate the problem of dealing with the increased uncertainty around potential output, policymakers should put a higher premium on two important aspects of monetary policy: (1) understanding the true nature of the fall in potential output that the crisis is likely to have caused; and (2) strongly communicating their views on potential output on which they are basing their policy rate decisions and emphasizing their commitment to adjust as new information becomes available.
Impact of the Crisis on Fiscal Policy
Just like monetary policymakers, governments across Europe have reasons to worry about the impact of a decline in potential growth on fiscal policy. In fact, the crisis has dealt a double blow to fiscal policy: it will have to adjust to a weakening growth outlook at least in the short and medium run and, at the same time, deal with the fiscal ramifications of the crisis, including large-scale government interventions in the financial sector.
A negative shock to potential growth, even if only temporary, will lead to budget shortfalls because structural (that is, noncyclical) revenues will fall and structural expenditures increase. And while policymakers are rightfully willing to let automatic stabilizers work, they have reason to limit the structural deterioration of the fiscal balance during the crisis period. In the longer run, the European fiscal horizon is dominated by mounting pressures stemming from a quickly aging population. Expectations of age-related increases in pension, health care, and transfer spending generate strong incentives for policymakers to keep debt levels low to safeguard the fiscal space needed to deal with this challenge.29 Given the fiscal adjustment necessary to meet such challenges, any deterioration in the structural fiscal position caused by a drop in potential GDP growth would make that goal harder to achieve.
In addition, however, the crisis has forced policymakers to use fiscal resources for interventions in the financial system, both directly and indirectly through guarantees. The available estimates of the direct crisis-related costs and the indirect costs associated with government guarantees suggest that financial sector interventions will add considerably to public debt. This debt effect will heighten the urgency of any fiscal adjustment caused by the impact of the crisis on growth.
Fiscal Impact of Lower Potential Growth
The decline in potential growth in the short to medium term is subject to considerable uncertainty (see Chapter 2). How would different potential growth paths influence the fiscal position over this time horizon? One way to illustrate the impact of the crisis is to look at the implied deterioration of the structural fiscal balance compared to the “trend” benchmark of continued precrisis potential growth. The structural balance is a conceptual interpretation of the fiscal budget based on an estimate of the noncyclical share of expenditures and revenues. For a given level of GDP and fiscal budget, standard methods for computing the structural balance suggest that a reduction in potential growth will lead to a reduction in the structural balance for a given fiscal policy (Girouard and André, 2005; and OECD, 2006).
Indeed, the structural balance for the euro area can be shown to deteriorate significantly under alternative scenarios for the shortfall in potential output over the period 2009–14 (Figure 17).30
Euro Area: Potential Output Scenarios, 1999–2014
(Index, 1999=100)
Source: IMF staff calculations.Note: Trend growth matches the average potential growth 2000–08 of about 1.9 percent.Taking the time path of the GDP growth over the period as given, the annual structural deficit will be on average about 0.6 percentage points higher under the “crisis” scenario (average potential growth of 0.5 percent per year) than under the “trend” benchmark of continued potential growth at precrisis levels (average 1.9 percent per year). The accumulated difference reaches more than 3 percentage points over the full five-year period. The deterioration would be lower under the “upside” scenario (average potential growth of 1.5 percent per year) but obviously considerably higher under the “downside” scenario (average potential growth of –0.5 percent per year), with accumulated differences of about 1 and 5½ percentage points over the full period, respectively. Thus, while errors in the structural balance due to potential output revisions tend to be small for any given year (OECD, 2008), changes in potential as the result of the current financial crisis are likely to become large enough to influence estimates of an economy’s longer-term fiscal position—causing a prolonged deterioration of the structural balance in the absence of corrective action.
The growth effects of the crisis on the structural fiscal balance are likely to be large enough to trigger adjustments from policymakers committed to a certain time path for the structural balance due to national commitments or linked to the medium-term objectives of an EU stability program or to the excessive deficit procedure (EDP) under the Stability and Growth Pact (SGP).31 For instance, for most euro area countries and many other EU members that are entering or have already entered the EDP, standard practice would imply that they eventually be asked to reduce their structural deficits to the tune of at least 0.5 percentage point of GDP per year until a balanced structural budget is reached. Gauging the required adjustment effort, however, will need to take into account both the potential growth and the debt effects of the crisis.
The One-Two Punch of the Crisis in the Longer Run
A simple simulation exercise can shed light simultaneously on the growth and the debt effects of the crisis in the longer run, as well as their interaction, while allowing the introduction of a simple sustainability anchor for fiscal policy. To establish a counterfactual, consider a benchmark case without a crisis in which policymakers have resolved to steer fiscal policy to debt levels compatible with the EU-set SGP target of 60 percent by 2020 or 2030. The question is, how will the required primary fiscal balance have to change compared to this benchmark to reach the SGP target once the crisis is taken into account?
Just how sizable the impact of the crisis will be on longer-run fiscal policy depends on its growth effects (see above) and on its impact on public debt. The crisis will lift the debt level through two channels. One is the cyclical deterioration of the budget, which for the 2008–10 period the World Economic Outlook estimates at a cumulative 16 percent of GDP for advanced and 10 percent of GDP for emerging European countries (Figure 18), though with considerable cross-country variation. The other is the extensive use of the public balance sheet to shore up the financial system, including direct support measures such as capital injections and asset purchases and guarantees. As of June 2009, the estimated fiscal impact of up-front financial sector help varies between 0.7 percent of GDP in Italy and 13.6 percent in the Netherlands, with an average for euro area countries of about 5 percent (Horton, Kumar, and Mauro, 2009). The net fiscal costs of these measures, which exclude central bank support, could be lower should the actual demand for support continue to fall short of what governments have offered. In principle, the possible impact of fiscal guarantees is higher, with many countries having extended guarantees between approximately 10 and 30 percent and reaching about 200 percent of GDP in Ireland. Although the fiscal implications of guarantees are particularly difficult to evaluate, they have been estimated to fall between 2 and 5 percent of GDP (IMF, 2009d). Either way, however, the debt impact of the crisis is likely to create a sizable need for fiscal adjustment. In addition, it is also likely to influence the size of the adjustment necessitated by the growth effects of the crisis.
Selected European Countries: Projected Changes in Public Debt
(Percent of GDP; change end-2007–end-2010)
Sources: IMF, World Economic Outlook; and IMF staff calculations.To gauge the broad impact of the crisis on the longer-term health of public finance, policymakers can compare the fiscal adjustment needed under different assumptions to the benchmark case (Table 7).32 The simulation has two dimensions capturing the already familiar growth scenarios and alternative assumptions on the debt effect.33
Fiscal Adjustment Required in Response to Various Crisis Scenarios
(Increase in primary balance, percentage points of GDP)
Fiscal Adjustment Required in Response to Various Crisis Scenarios
(Increase in primary balance, percentage points of GDP)
| Debt shock | ||||||||
|---|---|---|---|---|---|---|---|---|
| SGP target by 2030 | SGP target by 2020 | |||||||
| Growth shock | 5 | 10 | 20 | 30 | 5 | 10 | 20 | 30 |
| Crisis upside | 0.3 | 0.5 | 1 | 1.5 | 0.6 | 1 | 1.8 | 2.7 |
| Crisis | 0.5 | 0.8 | 1.2 | 1.7 | 0.9 | 1.4 | 2.3 | 3.2 |
| Crisis downside | 0.7 | 1 | 1.5 | 2 | 1.3 | 1.8 | 2.7 | 3.6 |
Fiscal Adjustment Required in Response to Various Crisis Scenarios
(Increase in primary balance, percentage points of GDP)
| Debt shock | ||||||||
|---|---|---|---|---|---|---|---|---|
| SGP target by 2030 | SGP target by 2020 | |||||||
| Growth shock | 5 | 10 | 20 | 30 | 5 | 10 | 20 | 30 |
| Crisis upside | 0.3 | 0.5 | 1 | 1.5 | 0.6 | 1 | 1.8 | 2.7 |
| Crisis | 0.5 | 0.8 | 1.2 | 1.7 | 0.9 | 1.4 | 2.3 | 3.2 |
| Crisis downside | 0.7 | 1 | 1.5 | 2 | 1.3 | 1.8 | 2.7 | 3.6 |
A first insight is that the impact on fiscal policy is sizable. Even under the most benign set of assumptions, if the debt increase related to the crisis were only 5 percentage points of GDP and its impact on potential growth during the crisis were limited to the “upside” scenario (see Figure 17), the average annual primary fiscal surplus required to bring debt back to the SGP target by 2030 would increase by about 0.3 percentage point of GDP, compared to the benchmark (Table 7, left panel), or by 0.6 percentage point if the same target were to be reached by 2020 (right panel). Moving toward less benign growth assumptions considerably darkens the picture. For instance, the “crisis” growth scenarios cause the primary balance required to reach the debt target by 2030 or 2020 to rise to 0.5 or 0.9 percentage point of GDP, respectively.
The effect of higher debt on the required fiscal adjustment may be even larger. For example, keeping with the optimistic “upside” growth scenario but changing the assumptions about the debt increase to a more realistic 10 or 20 percentage points of GDP, the increase in the debt level will move the required fiscal adjustment relative to the benchmark to 0.8 and 1.2 percentage points of GDP, respectively, and nearly twice as much under the accelerated consolidation schedule.
Finally, the simulation illustrates how the impact of the crisis on public finances works through both the growth and the debt effect. The most plausible combination of assumptions of what Europe’s fiscal policymakers will be facing in the aftermath of the crisis is a combination of the “crisis” growth scenario and an increase in debt of 10–20 percentage points of GDP. Depending on how ambitious the timeline for consolidation is, this estimate translates into a very sizable necessary fiscal adjustment, ranging between 0.8 and 2.3 percentage points of GDP. And, clearly, both effects are responsible for some of the more extreme possible outcomes. This joint responsibility is underscored by the fact that the growth effect is not independent of the debt level at which it occurs: the drop in growth in output will weigh more on fiscal policy and will require a (somewhat) larger fiscal adjustment if it occurs under higher debt.34
Where does this leave individual European countries? For a selection of advanced EU economies, the estimated fiscal consolidation required to reach the SGP debt target by 2020 will depend on the precrisis debt level and the expected debt increase during 2009–10.35 The results are quite diverse (Figure 19), ranging from drastic required improvements in the average primary balance of 5 percentage points of GDP or more for Belgium, Greece, and Italy to still exacting requirements in the range of 2–3 percentage points for Austria, France, Germany, and Portugal.36 In most cases, starting debt levels seem to be the key driver of country dispersion, with the notable exceptions of Ireland and the United Kingdom; these two countries experienced particularly large increases in crisis-related debt. Generally, the results confirm the urgency of fiscal consolidation in the aftermath of the crisis.
Implications for Fiscal Policy
The one-two punch delivered by the crisis to Europe’s public finances is likely to generate a sizable fiscal challenge. The uncertainty surrounding the anticipated change to potential output puts a question mark beside the precise dimension of its growth effects, while the debt effects could vary greatly depending on the net costs of financial sector interventions and, in particular, the take-up of government guarantees. There is little doubt, however, that fiscal balances will have to improve significantly to meet targets for structural balances and ensure that longer-term sustainability needs are met. The fact that these problems come on top of an already difficult fiscal agenda—the high expected spending needs related to aging, revenue losses across Europe, and, in some cases, already elevated levels of debt—will exacerbate the challenges of a crisis-forced fiscal adjustment.
Meeting that challenge has various policy implications. One obvious consequence for policy more generally is the pressing need to boost potential growth to limit the fiscal damage threatened by the growth effect of the crisis (see also Chapter 2). In addition, the combination of already looming age-related fiscal pressures in Europe and the expected size of the fiscal impact of the crisis makes fiscal adjustment urgent. Thus, while the exact amount of the damage to public finances will remain uncertain for some time, policymakers should exercise extreme caution and start the required consolidation as soon as the state of the cycle allows, focusing on areas that promise swift and lasting results.
Also, policymakers should anchor market expectations by clarifying the desired fiscal policy path and the accompanying measures. A reversal of crisis-related spending initiatives will reduce the deficit but will need to be complemented by further efforts to contain spending growth below nominal GDP growth. Indeed, successful fiscal adjustment is likely to place greater emphasis on spending cuts rather than tax increases, as the tax burden is already high in many European countries. Prioritization of spending should be undertaken through comprehensive expenditure reviews, which would help identify spending inefficiencies to be eliminated. Pension and health care reforms will be key elements in the adjustment—measures to contain aging-related spending would include increases in retirement age. Savings to the budget could also come from better targeting of welfare payments, which would also enhance incentives to work or from civil service reforms aimed at better aligning the public sector wage bill with performance and needs. The expected cyclical recovery of revenues could be complemented with a review of tax policy, aimed at further simplifying the tax system to facilitate tax administration and make the system less distortionary while broadening the tax base.
Improving fiscal frameworks will also help mitigate fallout from the crisis and safeguard fiscal sustainability in the medium run (see also IMF, 2009d). Such mitigation could be achieved by introducing new national fiscal rules or strengthening existing ones and enhancing the preventive arm of the SGP—for instance, through giving greater commitment power to medium-term objectives and linking them to debt levels.
Finally, mirroring some of the implications for monetary policy, policymakers may find it advantageous to communicate clearly the reasons for the required fiscal belt-tightening, once the crisis has abated and the need for fiscal support to uphold aggregate demand becomes less urgent. While transparency is somewhat less an issue for fiscal policy in economic terms (to some extent, the increased public debt will speak for itself), shoring up the required public support might still be challenging—especially when it comes after a period of widespread economic hardship. Here, it could be helpful to lay out the various ways in which the crisis has contributed to fiscal shortfalls and stress the benefits of creating fiscal space for the tasks ahead, such as the ability to meet some of the aging-related pressures and sustaining the ability to use fiscal policy as an effective tool for macroeconomic stabilization.
Note: The main authors of this chapters are Helge Berger and Emil Stavrev.
This is the so-called flexible price potential output rooted in the standard macroeconomic literature but often difficult to identify empirically. Coenen, Smets, and Vetlov (2009)—using a large-scale model developed by ECB staff—find that the flexible price output gap (that is, the percentage difference between actual and flexible price potential output) for the euro area displays larger fluctuations than some conventional statistical or longer-term measures of the output gap.
See Woodford (2003) and Galí (2008), among others, for a discussion.
See, among others, Orphanides and others (2000); Orphanides (2001); Orphanides and van Norden (2002); Orphanides and Williams (2003); Musso and Westermann (2005); Proietti, Musso, and Westermann (2007); and Weidner and Williams (2009).
The uncertainty around output gap estimates is further exacerbated by the difficulty in disentangling in real time the type of shocks hitting the economy (permanent supply shocks versus cyclical demand fluctuations). For example, potential growth may be lower for a protracted period of time following the crisis, as resources from sectors that were affected by the crisis get allocated to other productive spheres. Indeed, given structural rigidities in the euro area, most analysts anticipate a prolonged impact of the crisis on the economy working mostly through the supply channel. Nevertheless, the long-run growth potential of the euro area is not expected to be significantly altered. In addition, the financial crisis may have affected monetary policymaking in other ways, for instance, by changing the effectiveness of transmission channels (see, for example, Cihák, Harjes, and Stavrev, 2009).
The quasi “real-time” output gap is calculated in the following way. In a first step, the full sample of real GDP (1970:Q1 to 2009:Q1) is split in two parts, with 1993:Q1 assumed to be the last observation from the point of view of policymakers. Policymakers then compute the real-time output gap for that quarter as the log difference between the actual output and its Hodrick-Prescott filtered value over the period 1970:Q1–1993:Q1. When new real GDP data arrives the following quarter, the exercise is repeated until, eventually, 2007:Q2 is reached. The true output gap is estimated over the full sample (1970:Q1–2009:Q1), but the comparison of the real-time output gap and the true gap ends with 2007:Q2 to alleviate end-of-sample problems in estimating the true output gap.
Extending the data used for the real-time filtering exercise with available forecasts mitigates but does not solve the problem in practice—see, for instance, the discussion in Cotis, Elmeskov, and Mourougane (2004).
Heterogeneity in beliefs is a very practical concern. For instance, Berger, Ehrmann, and Fratzscher (forthcoming) identify persistent heterogeneity in interest rate forecasting accuracy of ECB watchers, which, in part, can be traced back to locational factors, including regional economic conditions and differences in forecasting models. Beck, Hubrich, and Marcellino (2009) show that inflation differences in the euro area remain sizable and that only about half the variation in inflation rates in a selected sample of euro area countries is accounted for by area-wide factors.
Ehrmann and Smets (2003) also show that, while it may be optimal to reduce the weight put on the output gap in the presence of informational problems, conventional Taylor-type approaches continue to perform relatively well.
The exercise is based on a standard dynamic stochastic general equilibrium model. It comprises forward-looking but persistent Phillips curve and aggregate demand equations and a Taylor-type reaction function conditioning the nominal interest rate on deviations of inflation from its target and the output gap. Potential output estimates are model consistent. The model is estimated using Bayesian techniques on euro area quarterly data from 1993Q1 to 2007:Q2, avoiding the current crisis period.
A zero-mean autoregressive term is added to the output gap term in the Phillips curve equation, allowing prices to evolve temporarily according to the public’s beliefs about the output gap, while policymakers react to their own estimates of the output gap. The difference in beliefs is common knowledge.
Note that given the sizable increase in the central banks’ balance sheets as a result of the implementation of various unconventional measures, a reversal of the monetary policy stance before their expiration could be costly. Nevertheless, policymakers would need to be ready to bear such costs in order not to compromise the primary goal of monetary policy to maintain price stability.
For instance, the ECB’s regular “economic analysis” provides a useful avenue for such a specific communication. In particular, at the time of the exit, the ECB would need to explain in its “economic analysis” that the decision to raise interest rates was based, among other things, on strong indications for inflationary pressures over the policy horizon due to an exceptionally steep decline in potential output compared to its precrisis trend, while, at the same time, emphasizing the uncertainty around these indications and its readiness to avoid any excessive tightening should the incoming data point to an overestimation of the fall in potential.
The European Commission (2009a) predicts that, on average, the euro area will see its age-related spending increase by more than 3 percentage points of GDP between 2007 and 2035—an estimate with considerable upside risks (IMF, 2009a).
The point can be illustrated by a simple “rule-of-thumb” calculation, in which structural revenues are assumed to be 45 percent of potential output (around the historical average for the euro area over the past decade), while structural expenditures remain unchanged. Under this assumptions, a 1 percent deterioration of the potential output results in 0.45 percentage point deterioration of the structural balance.
See IMF (2009d) for a more detailed discussion of medium-term objectives and the mechanics of the EDP in the current crisis. Increasingly, national fiscal frameworks also define structural fiscal targets. For instance, Germany has recently put into place a fiscal framework setting a specific goal for the structural balance (see Chapter 1).
See Horton, Kumar, and Mauro (2009) for a comparable comparison of the consolidation needs across a larger number of advanced and emerging economies.
The calculation is quite standard. The benchmark assumes a starting debt level in line with historical euro area data for end-2007, a constant real interest rate of 2 percent, inflation of 2 percent, and real GDP growth at 1.9 percent, implying nominal GDP growth (y) of about 3.9 and nominal interest rates (i) of 4 percent. The debt-to-GDP level evolves according to d(D/Y)t = (B/Y)t + (i – y)/(1 + y)(D/Y)t –1, where D is the nominal debt level, Y the level of nominal GDP, and d indicates the change of the debt ratio over time. The calculations underlying Table 7 assume that the starting debt level is increased by the amount stated compared to its benchmark level and that the growth path of potential output 2009–14 is as described in the scenarios illustrated in Figure 16 and indicated by the table columns. Beyond 2014, growth is assumed to return to its historical level (1.9 percent). By construction, the results are very robust to changes in the starting debt level assumed for the benchmark case.
This is simply because the debt level “weighs” the growth effect in the evolution of the debt-to-GDP level (see the description above). For example, moving from the “upside” to the “downside” growth scenario requires about 0.2 percentage point of GDP higher fiscal adjustment if the assumed debt impact is 30 rather than only 5 percentage points in the case that the SGP target is to be reached by 2020 (Table 7).
The exercise is otherwise similar to the one underlying Table 7. Growth rates are assumed to follow the “crisis” scenario.
Some countries show “negative” required improvements, which reflects starting debt levels below the assumed target level of 60 percent of GDP; these include Luxembourg, the Nordic countries, Slovenia, and Switzerland.
