Is the output gap smaller than we think?
Economist Kevin Kliesen at the St. Louis Fed asks that question in an article he published today.
In its 2009 Annual Report, the Bank for International Settlements discussed these “bubble-induced distortions” to current estimates of trend output growth and, hence, potential real GDP. Thus, it is conceivable that estimates of potential real GDP at the start of the recession were too large and that … structural adjustments … may have subsequently reduced potential real GDP from its artificially high level.While it is probably unlikely that the fall in actual real GDP during the recession has been matched by the fall in potential real GDP, the size of the output gap might be smaller than conventional wisdom might believe. If so, those who foresee little risk to the near-term inflation outlook because of a large, persistent output gap may be too optimistic.
Krugman Keynesians argue that the output gap restrains wage-push inflation and therefore the Fed and Treasury can stimulate without fear of sparking inflation so long as the unemployment rate is high.
But what is a high unemployment rate? Just as output was goosed by the credit bubble, so too was employment.
Kliesen argues that Bernanke has less room to maneuver than he thinks.