The output gap is like a lot of things in economics: It works in theory
Don't mind the gap
The Bank of Canada was talking about the output gap way before it was popular. It's been the central bank's guiding light for years. A report the BOC released Friday shows they might be having second thoughts.
The output gap is a simple concept. An economy has a speed limit -- an amount it can grow before sparking inflation. The gap is how much below the speed limit the economy is operating.
If there is a big gap, like there was after the crisis, then you can stimulate an economy for years before it gathers enough speed to test the limit. It all makes perfect sense.
The problem, as the BOC outlines, is that the output "is unobservable and highly uncertain". Essentially, you don't know what the speed limit is. And if productivity improves, the speed limit moves higher.
There are all kinds of ways to estimate the output gap but the new study from the BOC suggests they're not very at forecasting when inflation will appear.
"We find that most output gap estimates do not appear to add much information to simple models with lags of inflation in forecasting total CPI inflation and CPI-median," the study says.
More importantly, they found that using real-time data did little to understand the output gap and what it meant for inflation.
Ultimately, this report should once again humble central bankers. In a globalized world it's even more difficult to predict or observe when an economy is running at full capacity.
It all begs a different question: Instead of having an inflation target, maybe central banks should have a wage inflation target?