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Dismiss the output gaps? To use with caution given their limitations

Lise Pichette (), Marie-Noëlle Robitaille, Mohanad Salameh and Pierre St-Amant ()

Economic Modelling, 2019, vol. 76, issue C, 199-215

Abstract: The link between inflation and the output gap is central to the conduct of monetary policy. In this paper, we use a new real-time database for Canada to study various output gap measures. We analyze output gap revisions and assess the usefulness of these gaps in forecasting total CPI inflation and three newly developed measures of core CPI inflation: CPI-median, CPI-trim and CPI-common. We also consider labour input gaps, projected output gaps, and simple combinations of output gaps. We find that, when forecasting CPI-common and CPI-trim, some gaps appear to provide information that reduces forecast errors when compared with models that use only lags of inflation. However, forecast improvements are rarely statistically significant. In addition, we find little evidence of the usefulness of output gaps in forecasting inflation measured by total CPI and CPI-median. These results call for cautiousness when central banks use output gaps to forecast inflation as their usefulness is limited.

Date: 2019
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