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Pre-election Economic and Fiscal Update 2017

Uncertainty surrounding estimates of the output gap

The output gap is a measure of spare capacity in the economy. It is used to help forecasters determine inflationary pressures. However, the output gap is an unobservable variable so forecasters must estimate the output gap in order to understand the underlying state of the economy. Estimates of the output gap are, by their nature, highly uncertain and depend on different methodologies and assumptions. It is therefore useful to compare our estimate with those of other forecasters.

The output gap is the difference between actual GDP and potential GDP (the level of GDP that will stimulate excess inflation if exceeded). In this way the output gap is an estimate of the cyclical position of the economy and a measure of the degree of spare capacity. A positive output gap suggests the economy is operating above its potential level and capacity constraints are beginning to affect the economy. This would typically suggest that the economy has less room to grow, prices are likely to rise and, all else unchanged, less of the operating balance is structural (see box Summary fiscal indicators on page 33 for more details). We estimate the output gap is below zero at -0.5% on average in 2016/17.

Figure 3.3 shows the Treasury's estimate of the output gap relative to a range of other estimates[15]. For most of the sample period our estimate of the output gap is near the centre of the range of forecasts (the blue area) and close to the average (the green line). However, from 2011 onwards our estimate diverges somewhat and has been the lowest in the sample over the past few years.

Figure 3.3 - Output gap estimates
Figure 3.3 - Output gap estimates.
Sources: IMF, OECD, the Treasury and others

Given that the output gap is unobservable, forecasters look at a range of observable data to help inform estimates of the output gap. Some key indicators include non-tradable inflation, labour market data and businesses surveyed opinions of capacity.

The Treasury's current lower output gap estimate implies a more optimistic view of potential GDP; that is, we believe the economy has more room to grow than other forecasters. In part, this view reflects the persistent weakness in non-tradable inflation over the past four years, and the degree of spare capacity that we see in the labour market, particularly in light of recent strong migration. However, this view is becoming increasingly challenged by persistently strong survey measures of capacity (such as the Quarterly Survey of Business Opinions) which have been showing that businesses are facing significant capacity constraints. In light of this and other evidence we have revised up our view of the output gap from the Budget Update. Given the high degree of uncertainty surrounding the output gap and its importance for understanding the underlying state of the economy and subsequent inflationary pressure, it is crucial that we review our estimation and interpretation of the output gap regularly.


  • [15]The sample includes eight other forecasters of the New Zealand economy including the IMF, the OECD, the Reserve Bank and a range of commercial banks.
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