Output Gaps in Real Time: Are They Reliable Enough to Use for Monetary Policy?

The output gap – the difference between actual and potential output – is widely regarded as a useful guide to future inflationary pressures, as well as an important indicator of the state of the economy in its own right. Since the output gap is unobservable, however, its estimation is prone to error, particularly in real time. Errors result both from revisions to the underlying data, as well as from end-point problems that are endemic to econometric procedures used to estimate output gaps. These problems reduce the reliability of output gaps estimated in real time, and lead to questions about their usefulness. We examine 121 vintages of Australian GDP data to assess the seriousness of these problems. Our study, which is the first to address these issues using Australian data, is of interest for the method we use to obtain real-time output-gap estimates. Over the past 28 years, our real-time output-gap estimates show no apparent bias, when compared with final output-gap estimates derived with the benefit of hindsight using the latest available data. Furthermore, the root-mean-square difference between the real-time and final output-gap series is less than 2 percentage points, and the correlation between them is over 0.8. Our general conclusion is that quite good estimates of the output gap can be generated in real time, provided a sufficiently flexible and robust approach is used to obtain them.