FRBSF Economic Letter
2003-14; May 30, 2003
Minding the Speed Limit
Economists generally agree on the importance of low and stable inflation
as a primary goal of monetary policy, as well as on the key role of inflation
and forecasts of future inflation in providing critical signals to which
the Fed needs to react. Economists also agree that the measure of real
activity relevant for monetary policy is the gap between the level of
actual output and an underlying trend level of output. Most central banks
view such an output gap as both a policy objective to be stabilized and
as an important signal of future inflation developments. However, some
economists argue that difficulties in measuring the economy's underlying
trend output level make any estimate of the output gap too poorly measured
to be a useful guide for monetary policy.
This Economic Letter discusses policies that focus on whether
the economy is growing faster or slower than trend output rather than
on what the level of output is relative to the level of trend output.
Such policies are called "speed limit policies," where the growth
rate of trend output represents the economy's safe sustained speed limit--faster
growth generates inflation over time, and slower growth leads to increased
unemployment. When actual output grows faster than trend, the output gap
is increasing; when actual output grows more slowly than trend, the gap
is falling. Speed limit policies, therefore, focus on how the output gap
is changing rather than on its level. Speed limit policies may alleviate
some of the measurement problems that affect estimates of the level of
the gap; they also may impart a persistence to policy actions that improves
the trade-off between inflation and output stability.
The output gap measures actual output relative to some benchmark level.
Recent theoretical work suggests that the benchmark should be the level
of output that occurs when all wages and prices are flexible and adjust
to balance supply and demand in all markets. Since not all wages and prices
are flexible, this output level cannot be observed directly, so in practice,
the benchmark is commonly interpreted to be the trend level of output.
But there are many different ways to estimate trend output, and each can
give conflicting signals about whether the output gap is positive or negative,
large or small.
Orphanides (2000) has provided evidence that the problems of mismeasuring
the output gap produced policy mistakes during the 1970s. Today, with
hindsight, we know that productivity growth slowed in the early 1970s.
At the time, however, this was not clear. As a result, policymakers overestimated
the level of trend GDP and therefore believed the output gap (actual output
minus the estimated trend level) was more negative than it actually was.
Over time, these errors grew in size as trend output fell further and
further below the estimated level. To counteract what was thought to be
a weak economy, the Fed followed an expansionary policy, contributing
to the high inflation the U.S. experienced during this period. In light
of Orphanides's research, some economists have argued that the output
gap is measured so poorly it should not be given much importance in Fed
deliberations (McCallum 2001).
1 illustrates this problem in the simple case where the growth rates of
actual output and trend output fall from 4% to 2%. If the central bank
continues to believe the trend growth rate is 4%, the dotted line shows
how the estimated output gap would grow over time, even though the actual
gap remains at zero; a central bank focusing on the level of the estimated
gap would believe larger and larger interest rate cuts were required.
Real-time errors in predicting the economy's trend output arise from
two sources. First, the predictions depend on currently available data
on GDP, which are revised over time as more information becomes available.
Second, even if completely accurate data were immediately available, trend
GDP still would be difficult to estimate. For example, only as more time
passes will it be possible to tell how much the technology boom of the
late 1990s altered the economy's trend growth rate--our assessment of
trend growth in the 1990s will be better in, say, 2010 when we can look
both backward from 1990 and forward in time to the first decade of the
2000s to see how the economy has grown. According to Orphanides and van
Norden (2002), this second source of error, not data revisions, is the
major problem in measuring the current level of trend output and therefore
in measuring the output gap.
way to assess measurement errors in the output gap is to compare estimates
made today based on data for the period 1970-2002--"final estimates"--to
the preliminary estimates that could have been formed just looking backward
from each date in time. These two estimates of trend output can be combined
with data on actual GDP to obtain two different measures of the output
gap. The difference between the two estimates reflects revisions in the
estimated level of trend output and provides an estimate of the importance
of measurement error. The solid line in Figure 2 shows the difference
between preliminary and final estimates of the level of the gap; clearly,
these differences can be quite substantial. The dashed line shows the
differences in the estimated growth rate of output relative to trend growth
(the speed limit), which are much smaller than those in the level measure.
This suggests that, rather than ignoring the output gap altogether, policymakers
might be better off focusing on the gap between the growth rate of output
and the growth rate of trend output, essentially the change in the output
gap. This type of focus was described by Federal Reserve Governor Edward
Gramlich in a 1999 speech:
Solving a standard model of the macroeconomy, such a policy would effectively
convert monetary policy into what might be called a "speed limit"
form, where policy tries to ensure that aggregate demand grows at roughly
the expected rate of increase of aggregate supply, which increase can
be more easily predicted.
description of a speed limit policy explicitly recognizes the difficulties
in measuring the level of trend output (aggregate supply) and argues that
its growth rate can be more easily predicted. When actual output grows
faster than trend output, policy should tighten; when actual output grows
more slowly than trend, policy should ease. The dashed line in Figure
3 shows the change in the estimated output gap after a drop in trend growth.
A central bank that focuses on this measure would cut interest rates in
response to the initial decline in the output gap but would not engage
in further cuts
Time inconsistency and policy biases
Another appeal of speed limit policies is that they seem to produce good
outcomes when the public's expectations of inflation matter for current
inflation and output. In particular, speed limit policies help alleviate
a policy problem known as the time-inconsistency of optimal policy (see
Dennis 2003). The heart of the problem is that people's decisions today
may depend on what they believe the central bank will do in the future.
Specifically, price- and wage-setting decisions by households and firms
depend on what they think inflation will be in the future.
This dependence has important consequences for the trade-offs between
inflation and output stability the central bank faces. For example, suppose
an adverse economic shock, such as a rise in oil prices, both raises inflation
and reduces output. To dampen the rise in inflation, the central bank
would need to raise interest rates, but this would exacerbate the decline
in output. If the central bank could commit to maintaining a tight monetary
policy for some time into the future, the public would expect lower inflation
in the future, and that would help dampen the current inflationary impact
of the oil shock. Current inflation could be stabilized with a smaller,
but persistent, fall in output.
The problem, as Dennis (2003) explains, arises if the public believes
the central bank is trying to stabilize both inflation and the output
gap. In particular, if the central bank succeeds in holding down current
inflation, albeit with some fall in output (and the associated rise in
unemployment), it no longer has an incentive to maintain its tight policy;
instead, it will reverse itself and switch to an expansionary policy to
close the output gap. With this belief in mind, the public will not expect
lower future inflation when the oil price shock occurs, and the only way
the central bank can dampen the rise in inflation is to slam on the brakes
to slow economic activity.
Following a speed limit policy obviates this problem. In this case, when
an adverse oil shock occurs, policy is tightened to stabilize inflation;
unemployment rises and the output gap falls. In subsequent periods, however,
the central bank will look at how the output gap changes rather than at
its level. Thus, it will not switch its policy stance simply because the
gap remains negative; it will become more expansionary only if the gap
becomes more negative (or inflation begins to fall). A speed limit policy
generates a more persistent tightening than does a policy that focuses
on the level of the gap. As a consequence, when an adverse oil price shock
occurs, the public will expect lower future inflation, and this helps
stabilize current inflation.
Using an economic model in which expectations are important for determining
inflation, Walsh (2003) finds that speed limit policies stabilize inflation
and the output gap better than do policies that focus directly on the
level of the output gap. The persistence introduced by speed limit policies
improves the trade-off between output and inflation variability faced
by the central bank. However, such policies do not do as well when expectations
are less important for determining inflation (Rudebusch 2002).
Does the Fed follow a speed limit policy?
The preceding discussion suggests that the problems of measurement errors
and stabilization may be alleviated by a speed limit policy. A separate
issue is whether the Fed has actually behaved in a manner consistent with
a speed limit policy as described in Governor Gramlich's speech.
Yash Mehra (2002) has estimated policy rules to explain the Fed's behavior,
and he finds that a Taylor rule using the change in the output gap does
as well in accounting for Fed policy during the Greenspan era as does
a traditional Taylor rule using the level of the gap, providing some evidence
that the Fed has minded the economy's speed limit and not solely the output
Carl E. Walsh
Professor of Economics, UC Santa Cruz,
and Visiting Scholar, FRBSF
Dennis, R. 2003. "Time-Inconsistent
Monetary Policies: Recent Research." FRBSF Economic Letter
2003-10 (April 11).
Gramlich, E.M. 1999. "Remarks," Wharton
Public Policy Forum Series, Philadelphia, PA (April 22).
McCallum, B.T. 2001. "Should Monetary Policy
Respond to the Output Gap." American Economic Review (May)
Mehra, Y.P. 2002. "Level and Growth Policy Rules
and Actual Fed Policy since 1979." Journal of Economics and Business
54(6) (Nov./Dec.) pp. 575-594.
Orphanides, A. 2000. "The Quest for Prosperity
without Inflation." European Central Bank Working Paper No. 15 (March).
Orphanides, A., and S. van Norden. 2002. "The
Unreliability of Output Gap Estimates in Real Time." Review of
Economics and Statistics (November).
Rudebusch, G.D. 2002. "Assessing Nominal Income
Rules for Monetary Policy with Model and Data Uncertainty." Economic
Journal 112 (April) pp. 402-432.
Walsh, C.E. 2003. "Speed Limit Policies: The
Output Gap and Optimal Monetary Policy." American Economic Review
93(1) (March) pp. 265-278.