Use of the output gap indicator at the CNB
Inflation in the Czech economy is determined both by external factors (e.g. prices of raw materials and foreign inflation) and by domestic factors. The domestic ones can be divided into supply factors (the koruna's exchange rate and productivity) and demand factors. The "output gap" is a frequently used aggregate indicator of the effects of demand factors. This indicator measures the difference between "potential output" and output in the current period. Potential output can be viewed as the level of output that can be produced and sold without giving rise to additional pressures for a change in prices.
The output gap therefore provides in concentrated form valuable information on the existence or absence of demand pressures in the economy. If output is above its potential value, prices will tend to rise. In this situation we speak about a positive output gap. Conversely, if output is below potential, prices will tend to fall and we speak about a negative output gap. The concept of the output gap thus effectively enhances the analysis of demand pressures and their potential price effects beyond the framework of work with GDP growth rates. This is why the Czech National Bank, in line with the practice of numerous analytical teams, uses the output gap in its analyses and forecasts.
However, the output gap is not usually an observable and measurable variable. It can be estimated in several ways. These include, for example, estimating potential output using the production function method or various filtering methods. Filtering here refers to a method for obtaining from a GDP time series those components which have a close relationship to inflation. In its analyses of past economic developments, the CNB uses a multivariate filtering method known as the Kalman filter. This method essentially involves applying ideas of the relationships between the output gap and key macroeconomic variables to past data. Analysis of the historical development of the relationship of key macroeconomic variables, conditioned on set linkages within a closed macroeconomic model, will then indicate the evolution of the output gap. These results are subsequently confronted with the results of the other aforementioned approaches and with expert opinion.
However, the output gap plays a key role not only in the analysis of past developments, but in particular in considerations regarding the future. It is thus an important part of the CNB's forecasting process. The output gap forecast, together with the assumptions regarding the exchange rate and imported inflation, is a key factor in the preparation of the CNB's macroeconomic forecasts, which form the basis for monetary policy decision-making. The CNB's forecast is based on the fact that the future path of the output gap is affected both by the lagged effects of past economic activity (known as persistence) and the settings of the interest-rate and exchange-rate components of the monetary conditions and the external economic environment. The monetary conditions are taken to mean actual values of the koruna's real exchange rate against the euro and of real interest rates with various maturities compared to their equilibrium values. Foreign economic activity is proxied with German GDP or the output gap. Easy monetary conditions, or a positive foreign output gap, then, put simply, generate pressures for growth of the domestic output gap and thus potentially also for a rise in prices.