Mind the Gaps! Financial-Cycle Output Gaps and Monetary-Policy-Relevant Output Gaps

Douglas Laxton (), Asya Kostanyan (), Akaki Liqokeli (), Gevorg Minasyan, Tamta Sopromadze () and Armen Nurbekyan ()
Additional contact information
Douglas Laxton: Saddle Point Research and The Better Policy Project
Asya Kostanyan: Saddle Point Research and The Better Policy Project
Akaki Liqokeli: National Bank of Georgia
Tamta Sopromadze: National Bank of Georgia
Armen Nurbekyan: Central Bank of Armenia

No 19, Working Papers from Central Bank of Armenia

Abstract: This paper develops measures of output gaps with a clear distinction between model concepts that are relevant for monetary policy and measures designed specifically for assessing financial-stability risks. It argues that failure to make a clear distinction between the two concepts can lead to misguided policies that could potentially result in central banks allowing long-term inflation expectations to ratchet downwards and possibly getting stuck in low interest rate traps with significant risks of deflation and financial instability. Moreover, the paper shows that the financial-cycle output-gap model (FCMOD) outperforms the traditional monetary-policy-relevant specification in predicting the medium-term projected level of GDP, so there is merit in using FCMOD forecasts as inputs into the monetary policy model (MPMOD) medium-term forecasts of potential output. The first measure, which goes to back to Arthur Okun in 1962 and is relevant for monetary policy, is used by inflation-forecasttargeting (IFT) central banks (CBs) to communicate how they are managing the short-run output-inflation trade-off. The second is a measure of the financial cycle and is based on a simple atheoretical model that incorporates information on the growth rates of real credit and real property prices. The paper develops empirical estimates for the U.S. and China (for the financial cycle). The estimates of the U.S. output gaps based on the financial-cycle concept are over twice as large before the global financial crisis (GFC) than the measures relevant for monetary policy. The estimates for China suggest that the financial-cycle output gap now is similar in magnitude to the U.S. estimates before the GFC.

Keywords: output gaps; financial cycles; monetary policy; financial stability; credit growth; property prices (search for similar items in EconPapers)
JEL-codes: C53 E32 E37 E44 E58 G01 (search for similar items in EconPapers)
Pages: 33 pages
Date: 2019-12
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Published in LSE Working Paper Series, December 2019

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Persistent link: https://EconPapers.repec.org/RePEc:ara:wpaper:019

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