Why Is The Bank Of Canada So Focused On The Output Gap?
Almost without exception, when announcing its rate decision, the Bank of Canada (BoC) refers to where the economy stands in relation to potential output. The BoC is primarily concerned with how fast the economy is closing the “output gap”. Laymen often find the concept of potential output rather abstract, yet it can easily be explained.“Potential output” can be viewed as a measure of the total supply of workers and capital investment available in an economy. Essentially, it refers to an economy’s capacity to produce goods and services when all available productive resources are fully utilized. Although it is a theoretical construct, it can be measured with some degree of confidence and central banks everywhere continually conduct research in this area. The central banks use the concept as a gauge of the economy’s relative performance.
The BoC considers the measure of potential output to be at the center of its formulation of monetary policy, since the output gap--- the difference between actual and potential output--- is one of the best means to measure inflationary pressures in the economy.[1]
The steady erosion of potential output growth has dogged all major economies. The accompanying chart, developed by the BoC, illustrates that Canada’s potential to grow has been on a steady downward trend since 2000. Potential GDP is contingent on population growth and its related expansion of the labor force. Population aging is the biggest single factor, despite the growth in immigration, holding back higher levels of output. Moreover, Canadian growth potential was adversely affected by the global financial crisis; output lost during the Great Recession has yet to be fully restored, despite improvements in business investment and some reductions in the unemployment rate. Optimistically, the Bank expects potential growth to expand at a rate of 2 per cent, yet this rate will still be below that achieved prior to the 2008 financial crisis.
Measuring potential output is most useful in explaining why real rates of interest are low, and in the case of Canada, are actually negative. (The bank rate is set 1.25 per cent and inflation is running around 2 per cent, putting the real rate at minus 0.75 per cent). As long as actual growth does not pick up speed, we can expect inflation to remain tame in and around the current level of 2 per cent. If GDP is growing at its potential then the current policy can be considered “neutral”; that is, monetary policy neither stimulates nor cools down the economy but attempts to keep it on an even keel while meeting its inflation target. When commentators write about the need to “normalize” rates of interest rates, they are saying, in effect, that the real rate of interest needs to be positive. They argue that negative real rates are inherently inflationary. Yet, Canada’s experience with negative real rates does not bear this out. As long as potential growth is flat-lined at 2 per cent, negative real rates do not pose any threat to meeting the inflation targets.
[1] Lawrence Schembri, Deputy Governor, The (Mostly) Long and Short of Potential Output. Remarks Ottawa Economics Association and CFA Society Ottawa Ontario, May 16, 2018
Negative rates have proven to not be the stimulus many economists hoped for.