Monetary policy and the output gap

Monetary policy and the output gap

Kjetil Olsen

Norges Bank

The objective of monetary policy in Norway

 The operational target of monetary policy shall be annual consumer price inflation of close to 2.5 per cent over time.

 Monetary policy shall also contribute to stabilising output and

employment.

Federal Reserve Act

The Board of Governors and the Federal Open Market Committee should seek

“to promote effectively the goals of

maximum employment, stable prices, and

moderate long-term interest rates.”

Dual mandate in most countries

 Price stability

 Stability in the real economy

 Theoretical representation:

 Minimising a loss function

( ) ^{2 ( ) 2}

k *

t t k

k 0

L E y

∞

= +

 

= ∑ β   π − π + λ  

Projected inflation and output gap in the baseline scenario

Percent. 2008 Q1 – 2015 Q4

-1 0 1 2 3 4 5 6

-4 -3 -2 -1 0 1 2 3 4

2008 2009 2010 2011 2012 2013 2014 2015

Output gap (left-hand scale) CPIXE (right-hand scale)

Source : Norges Bank

-4 -2 0 2 4

-4 -2 0 2 4

2008 2009 2010 2011 2012 2013 2014 2015

Output gap

-1 0 1 2 3 4 5

-1 0 1 2 3 4 5

2008 2009 2010 2011 2012 2013 2014 2015

CPIXE

-1 0 1 2 3 4 5

-1 0 1 2 3 4 5

2008 2009 2010 2011 2012 2013 2014 2015

CPI

0 1 2 3 4 5 6 7

0 1 2 3 4 5 6 7

2008 2009 2010 2011 2012 2013 2014 2015

Key policy rate

Baseline scenarios MPR 3/12

30%

50%

70%

90%

Sources: Statistics Norway and Norges Bank

Criteria for an appropriate interest rate path

1. The inflation target is achieved

2. The inflation targeting regime is flexible 3. Monetary policy is robust

“Loss function”:

Criterion 1

Criterion 2

Criterion 3

0 1 2 3 4 5 6 7 8

0 1 2 3 4 5 6 7 8

2008 2009 2010 2011 2012 2013 2014 2015

Criterion 1 Criterion 1&2 Criterion 1,2&3

Key policy rate – baseline scenario

Percent 2008 Q1 – 2015 Q4

Source: Norges Bank

Criteria for an appropriate interest rate path

1. The inflation target is achieved

2. The inflation targeting regime is flexible 3. Monetary policy is robust

“Loss function”:

Criterion 1

Criterion 2

Criterion 3

 Households maximise utility (consumption and leisure)

 Monopolistic competitive firms maximise profit

 Price rigidities

New Keynesian stylised model

 Households maximise utility (consumption and leisure)

 Monopolistic competitive firms maximise profit

 Price rigidities

 Welfare based loss function (inflation gap and output gap)

 Relevant Y* natural (flex-price) level

 Not smooth, vary with shocks

New Keynesian stylised model

 Difficult to communicate

 Model dependent

 Highlighting nominal frictions as source of welfare loss

 We take a broader view

Why not a flex-price gap

 “... the level of output that is consistent with the maximum sustainable level of employment: That is, it is the level of

output at which demand and supply in the aggregate economy are balanced so that, all else being equal, inflation tends to

gravitate to its long-run expected value.”

Mishkin 2007

Stabilising around what?

-4 -3 -2 -1 0 1 2 3 4 5 6

-4 -3 -2 -1 0 1 2 3 4 5 6

1995 1997 1999 2001 2003 2005 2007 2009 2011 MPR 3/12 HP gap

The output gap in MPR 3/12 and the output gap using the HP-filter ¹⁾

1) Lambda = 40 000 Sources: Statistics Norway and Norges Bank

 No structure/economics

 Volatile GDP-series

 Revisions in data

 End-problems

Why not HP-gap based on GDP?

-4 -3 -2 -1 0 1 2 3 4 5 6

-4 -3 -2 -1 0 1 2 3 4 5 6

2006 2007 2008 2009 2010 2011 2012

HP gap, GDP 2009Q4

The output gap using the HP-filter on the 2009Q4 GDP vintage

Sources: Statistics Norway and Norges Bank

-4 -3 -2 -1 0 1 2 3 4 5 6

-4 -3 -2 -1 0 1 2 3 4 5 6

2006 2007 2008 2009 2010 2011 2012

HP gap, GDP 2009Q4

HP gap, GDP 2012Q2

The output gap using the HP-filter on the 2009Q4 GDP and 2012Q2 GDP vintages

Sources: Statistics Norway and Norges Bank

-4 -3 -2 -1 0 1 2 3 4 5 6

-4 -3 -2 -1 0 1 2 3 4 5 6

2006 2007 2008 2009 2010 2011 2012

HP gap, GDP 2009Q4 HP gap, GDP 2012Q2 MPR 1/10

The output gap using the HP-filter on

different GDP vintages, and the output gap in MPR 1/10

Sources: Statistics Norway and Norges Bank

-4 -3 -2 -1 0 1 2 3 4 5 6

-4 -3 -2 -1 0 1 2 3 4 5 6

2006 2007 2008 2009 2010 2011 2012

HP gap, GDP 2009Q4 HP gap, GDP 2012Q2 MPR 1/10

MPR 3/12

The output gap using the HP-filter on

different GDP vintages, and the output gap in MPR 1/10 and MPR 3/12

Sources: Statistics Norway and Norges Bank

 Focus on current situation

 Qualified judgment

 Based on broad information set

 Information from labor market important

 Measures of capacity utilization

 Multivariate filters

How do we calculate?

-4 -2 0 2 4 6 8 0

1 2 3 4 5 6

1979 1983 1987 1991 1995 1999 2003 2007 2011

Unemployment (inverted, left-hand scale)

GDP mainland Norway (right-hand scale)

Four quarter change in GDP mainland

Norway and the registered unemployment rate

Sources: The Norwegian Labour and Welfare Service (NAV) and Norges Bank

-2 -1,5 -1 -0,5 0 0,5 1 1,5 2

-2 -1,5 -1 -0,5 0 0,5 1 1,5 2

2005 2006 2007 2008 2009 2010 2011 2012

The unemployment gap

Deviation from the average unemployment rate past 15 years

Sources: The Norwegian Labour and Welfare Service (NAV) and Norges Bank

1,5 2,0 2,5 3,0 3,5

1,5 2 2,5 3 3,5

2005 2006 2007 2008 2009 2010 2011 2012

Average past 10 and 20 years marks high and low, respectively Actual

Average 2005 - 2011

Annual real wage growth

3 year centered moving average. Percent

Sources: Statistics Norway, TBU and Norges Bank

Sources: Statistics Norway and Norges Bank

2005 2007 2009 2011

-2 -1 0 1 2 3 4 5

10 20 30 40 50 60 70 80

Capacity constraints, right-hand scale

Labour supply, right-hand scale

Output gap MPR 3/12, left-hand scale

Capacity constraints and

labour supply reported by the Regional network

and estimated output gap in MPR 3/12

Multivariate Kalman filter

 Equations Data

(1) y

= y

+ y

 y

= 2θ

cos(θ

)y

– θ

y

+ ω

 ∆y

= γ

+ ω

(2) π

= (1 - μ

)π

+ μ

(L) π

+ η

y

+ ν

 ∆π

= ω

(3) u

= φ

u

+ (1 – φ

)u

+ φ

(L)y

+ ν

 u

= β

+ u

+ η

 β

= β

+ ξ

(4) x

= β

x

+ (1-β

)x

+ β

(L)y

+ ν

 ∆x

= ω

∑

Registered unemployment rate Log GDP

Domestic inflation, quarterly change, annualised

Gross capital formation, private sector,

as share of GDP

Output gap and unemployment gap based on a multivariate Kalman filter

Percent. 1985Q1 –2012Q2

-6 -4 -2 0 2 4 6

-6 -4 -2 0 2 4 6

1985 1989 1993 1997 2001 2005 2009

Output gap

Unemployment gap

Sources: Statistics Norway and Norges Bank

Different calculations of the output gap ¹⁾

-3 -2 -1 0 1 2 3 4 5 6

-3 -2 -1 0 1 2 3 4 5 6

2005 2006 2007 2008 2009 2010 2011 2012

Unemployment gap, based on a multivariate Kalman filter

Output gap based on a multivariate Kalman filter

MPR 3/12

Unemployment gap, based on average unemployment rate past 15 years

1) The unemployment gaps are multiplied by factor 2 Sources: Statistics Norway, NAV and Norges Bank

Different calculations of the output gap ¹⁾

-3 -2 -1 0 1 2 3 4 5 6

-3 -2 -1 0 1 2 3 4 5 6

2005 2006 2007 2008 2009 2010 2011 2012

Unemployment gap, based on a multivariate Kalman filter

Output gap based on a multivariate Kalman filter

MPR 3/12

Unemployment gap, based on average unemployment rate past 15 years HP-gap

1) The unemployment gaps are multiplied by factor 2 Sources: Statistics Norway, NAV and Norges Bank

 Unobservable

 Difficult

 Relying on one variable and one method not very robust

 Our approach: several methods and broader information set

 In the end: Judgmental call

Summing up on the output gap