What Is the Output Gap and when Do We know It? Time-varying Uncertainty of the Federal Reserve's Output Gap Estimates

Abstract:

A factor stochastic volatility model estimates the common component to forecasts of the output gap produced by the staff of the Federal Reserve Board, its time-varying volatility, and time-varying, horizon-specific forecast uncertainty. The common component to the output gap forecasts identifies a persistent and highly procyclical business cycle. Unexpected increases to the output gap produce strong, persistent responses in other macroeconomic variables, indicating that the output gap is a valuable proxy of aggregate demand. However, forecasts of the output gap are very uncertain, even well after the fact: the standard deviation an estimate of the output gap eight quarters ago has a 70 percent credible region of about +/-.5 percentage points, the uncertainty surrounding output gap forecasts is much larger. Finally, increased macroeconomic uncertainty, as measured by the output gap's time-varying volatility, produces pronounced negative responses to other macroeconomic variables.