Special Reports: A New Framework to Estimate Potential GDP

Executive Summary

At last year’s Jackson Hole Economic Policy Symposium, Federal Reserve Chair Jerome Powell highlighted the importance of the natural unemployment rate, potential GDP and the equilibrium interest rate for monetary policy. He suggested such measures are similar to the celestial stars and will help the Federal Open Market Committee (FOMC) select an appropriate policy stance to achieve its dual mandate of price stability and maximum employment. Powell also addressed concerns that shifts in the market structure have created uncertainty around existing estimates.1 Previously, we developed a new methodology to measure the equilibrium interest rate (r-optimal)2 and natural unemployment rate (u-optimal).3 In this report, we present a new methodology for estimating potential GDP, GDP-optimal. Our method is an alternative to the Congressional Budget Office (CBO) potential GDP measure, which is widely used to gauge U.S. potential output. Changes in macroeconomic variables over time have caused traditional methods, like the CBO’s, to be an imprecise guide for monetary policy.

Our approach incorporates the evolving nature of the economy to estimate potential GDP, creating a more flexible method. We utilize a modified Okun’s law with u-optimal, growth expectations as inputs and time-varying weights. When actual GDP is near GDP-optimal it suggests that monetary policy may be neutral (neither accommodative nor restrictive) and inflationary or deflationary risks will be roughly balanced. GDP-optimal is consistent with various business cycle phases. Our approach to estimating potential GDP is therefore more effective than traditional methods, and would help policymakers gauge appropriate monetary policy.

Re-evaluating the Benchmark: CBO’s Potential GDP

In theory, if actual GDP is below potential output, then resources are underutilized and inflationary pressure is limited. In such a scenario, the FOMC would want to maintain an accommodative policy stance in order to boost economic output to potential. However, when actual GDP rises above its potential level, it suggests a risk of an overheating economy and rising inflation. When this occurs, the FOMC would want to hike rates in an effort to slow growth. One of the most widely known methods of estimating potential GDP is Okun’s law. 4 Okun’s law investigates the inverse relationship between GDP and the unemployment rate. It states that GDP will exceed its potential level when unemployment falls below the natural unemployment rate. Conversely, when the unemployment rate exceeds its natural level, GDP drops below potential.

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