Charles Plosser of Philadelphia Fed in his recent speech speaks on output gaps. He is more optimistic on growth outlook than others:
Thus, while forecasting in the current environment is tricky, many forecasters, myself included, expect the second quarter of this year to exhibit a less severe decline in real GDP. Yet, I remain relatively optimistic and expect positive but modest growth in the second half, making fourth-quarter to fourth-quarter real GDP growth only slightly negative for 2009.
I am also relatively optimistic about growth next year. In fact, since January, I have not changed my growth forecast for 2010 or 2011. I expect the recovery to gain traction in 2010, with growth picking up to about 3 percent and then settling down to its long-run steady state of about 2.7 percent in 2011.
And the reasons are:
The broad outlines of this forecast are shaped by a view that the economy has suffered from a significant and persistent adverse shock to financial intermediation, manifesting itself in the form of the credit crisis. The consequences of this shock require significant real adjustments in the economy. For example, we are undoubtedly seeing a shrinking of the financial and housing sectors, and resources, both labor and capital, should flow into other parts of the economy. We cannot and we should not attempt to prevent these reallocations.
This suggests that the appropriate measure of the equilibrium level of national output is now lower than it had been previously. What’s more, this adverse shock is likely to persist for a while, and the necessary reallocations will take time to complete. Indeed, the economy’s potential output may be lower than previously estimated for some time. This means measures of the so-called output gap, the difference between the level of actual and potential output, will not be as high as they otherwise would be and may be volatile and hard to measure, especially since potential output is inherently unobservable. This is an important point to which I will return shortly.
Hmm. So he says potential output is now going to be much lower than what it was previously.
It makes sense actually though doubt whether the growth rates can still catch up. As pointed out earlier, Japan’s lost decade (if I may call so) was because of fall in productivity. Another way to say is that the potential output had fallen. However, despite the fall, the growth rates did not pick up because the loss in productivity was quite severe. Even in the case of US, the same logic can apply. Though, potential output might have declined (as much was because of financial services anyways), we don’t know whether growth rates can actually increase to catch up even with the fallen output.
Further he says:
My view of the economic outlook is also shaped in part by a forecasting model we are developing at the Philadelphia Fed. This model is based on what has become the workhorse model of modern macroeconomics. One of its key features is that expectations of future economic variables are forward-looking. Interestingly, this type of model produces a forecast that shows a significant recovery underway by the end of the year.
While I see somewhat more economic growth over the next 12 to 18 months than some private-sector forecasters, I also see less deflationary pressure in the near term than other forecasters, such as those in our latest Survey of Professional Forecasters. And I see greater risk of higher inflation over the intermediate to longer term.
He also provides link to the paper which explains the macroeconomic model. Not surprisingly, it uses the DSGE model (see my paper for an overviewas well) which has been at centre of criticism lately. I have never really used DSGE model (nor have the capability) but from whatever I read it ignores many of the problems we have in the economy. For instance, it hardly puts enough weightage on financial market frictions and assume markets to be efficient etc. We all know it is anything but true. I don’t know whether this model has made any changes.
Another point is forward looking nature of the model. Now in this crisis, we know one of the main issues was lack of historical data. As a result, much of the models used were forward looking with assumptions like housing prices will continue to rise, housing market prices will not fall across the country etc etc. I am wondering how forward looking models can be developed? Can we really peek into future for the entire economic framework? I have my doubts.
Anyways, nice point about potential output.