There is a lot of discussion of how economic slack is fast disappearing, and I expect a lot of push on this view, given continued rapid growth in GDP as reported in today’s second release for 2014Q3. This view seems counter to (1) the CBO estimate of potential GDP and (2) the slow pace of inflation. My suggestion is that there remains a substantial amount of slack out there.

In Figure 1, I plot log GDP as reported in today’s release, and potential GDP as estimated by the CBO in its August report.

Figure 1: Log GDP (blue), potential GDP as estimated by CBO (gray), and an estimate of potential GDP estimated by use of a modified Ball-Mankiw (2002) method (red). NBER defined recession dates shaded gray. Source: BEA 2014Q3 2nd release, CBO, An Update to the Budget and Economic Outlook (August 2014), NBER, and author’s calculations.

According to the CBO’s estimate of potential (if readers find my repetitive use of the adjective “estimate” tiresome, blame reader Tom), the current (estimated) output gap is -3.5% (in log terms). As I have discussed, there are a variety of other methods than the CBO’s (which is essentially a production function approach), including statistical detrending methods such as the Hodrick-Prescott filter (see [1] [2] [3])

I am going to use economics to infer the output gap and hence the level of potential GDP, i.e., exploiting the expectations-augmented Phillips curve. This means I am appealing to the following data.

Figure 2: Year-on-year core CPI inflation (blue), core personal consumption expenditures (PCE) deflator (red), and expected one year PCE inflation over the next year (green triangles). Source: BLS, BEA via FRED, Survey of Professional Forecasters.

The methodology is basically that forwarded by Ball and Mankiw (JEP, 2002), which involves inverting a simple expectations-augment Phillips Curve (without supply shocks, but allowing for random shocks), and assuming adaptive expectations (consistent with the accelerationist hypothesis).