Information rigidities and the news-adjusted output gap

Kevin Lee, Tony Garratt and Kalvinder Shields

Policy-makers in Treasuries or Central Banks often wish to know whether today's output is above or below trend. The gap between actual and trend output gives a sense of whether the economy is over-heating or falling into recession and is often used as an indicator of future inflation or as a trigger for interest rate adjustments. Measuring the gap is not straightforward though as it is difficult to separate out the trend from the business cycle and to distinguish very short-lived cyclical movements from more persistent ones. Failure to get this right means the associated gap measure could over-react to changes in output and the size and timing of any implied price pressures, say, will be misjudged. Policy based on the gap will also over-react to output change and generate unnecessary volatility. Against this background, a very useful source of information on the state of the economy is provided by surveys on what is expected to happen to output over the coming quarters. Survey responses on output expectations complement actual output data and give direct measures of those parts of observed output movements which respondents expect to last for some time and those parts which are expected to be reversed more quickly.

In this Nottingham School of Economics working paper, published in the Journal of Economic Dynamics and Control, Kevin Lee, Tony Garratt and Kalvinder Shields describe a method for isolating the 'news content' of published output data and of surveys on expected future output. This can then be used to construct an output 'gap' measure which incorporates permanent movements in trend output but which is also purged of fluctuations that are known to be very short-lived. The news content is found taking into account that, in reality, survey respondents may not have a complete picture of the economy themselves, potentially facing 'information rigidities' of different types. But having accommodated these complexities in a time-series analysis of actual and expected outputs, a news-adjusted gap measure can be obtained which takes into account output movements that are too short-lived to be influential on policy. Applying the methods to US data over 1970q1-2014q2, the new gap measure is shown to have very reasonable properties as a measure of the business cycle and provides a good leading indicator of inflation.

Journal of Economic Dynamics and Control, "Information rigidities and the news-adjusted output gap", by Kevin Lee, Tony Garratt and Kalvinder Shields.

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