A few weeks back, I offered some thoughts on how one might filter views on the trajectory of Federal Reserve funds-rate policy through the prism of a so-called "Taylor rule."  The posts are here and here, but as a brief reminder, I relied on a speech by then-Governor Ben Bernanke  to explain what the Taylor rule construct is all about:

A classic example of a simple feedback policy is the famous Taylor rule (Taylor, 1993). In its most basic version the Taylor rule is an equation that relates the current setting of the federal funds rate to two variables: the level of the output gap (the deviation of output from its full-employment level) and the difference between the inflation rate and the policy committee's preferred inflation rate.

These posts prompted the following, I presume not rhetorical, questions from Max Sawicky:

Based on the most recent data,

1.  How big is the output gap?

2.  What is the minimum acceptable or safe rate of unemployment?

3.  What is the maximum acceptable or safe employment to population ratio?

I have been remiss in not responding until now, but better late than never I guess.

To the first question, how big is the output gap?   Mechanically, that's an easy one to answer.  The estimated Taylor rule in the pictures from my earlier posts used an output-gap measure based on the Congressional Budget Office's estimates of potential GDP.  The current gap derived from this calculation is just a bit over 1 percent (where the gap is measured as potential GDP less actual GDP).  Here's what it looks like:

For my money, this is an upper bound on reasonable estimates of the output gap.  I say it is an upper bound because this way of calculating an output gap is, in fact, pretty old-fashioned.  In particular, it is not obvious that the CBO measure of potential conforms to our current understanding of how potential GDP ought to be measured.  To make the point, let me present a highly stylized version of the graph above:

Here potential GDP is assumed to evolve as a more or less straight-line through time.  As a consequence, all ups and downs in the trajectory of GDP represent inefficient deviations from the perfect white-line world.  If you are a really smart and really beneficent policymaker, you put on the brake when the red line is above the white line -- when actual GDP is above potential --  and step on the gas when the red line is below the white line -- when actual GDP is below potential.

It is apparent that this stylized view of the world corresponds almost exactly to the perspective taken in my calculations of the output gap based on the CBO potential output estimate.  The problem is that the straight white-line version of potential is the wrong construct to use in formulating monetary policy.

Here's a question that gets to the basic issue: Do you think the economy's potential pace of expansion is affected by a 60 percent rise in oil prices (about the actual percentage increase from this time last year)?   If you answer yes, then you probably (at least implicitly) envision a world that looks more like this:

In words, in the short-run there are lots of shocks that cause the potential of the economy to be higher or lower than average for some (perhaps extended) periods of time.  These ups and downs are not the result of monetary policy. Nor is it useful (or even possible) for monetary policy to counteract them.   In fact, by interfering with the natural functioning of market forces in the face of changing circumstances -- not all of which are desirable, of course -- monetary policy activism can make an already bad situation worse.

The point is not that output never falls below its potential -- in the last picture above there are still gaps between the red line and white line.  The point is that those gaps may often be a lot smaller than they appear on the basis of long-run trends or averages.

The oil-price increase referred to above was not, of course, an arbitrary example.  As I've argued in the past, it is my firm belief that energy-related price increases are a big part of the economic story for most of the period since the end of the last recession.  In the context of the current discussion, it means I believe that the current shortfall of GDP relative to its potential is probably a lot less than the 1 percent implied by the CBO-based numbers.  In fact, I'm willing to conjecture that there may be no output gap at all.   That doesn't mean that I think everything is hunky-dory.  It just means that there may be a limit on what we should expect from monetary policy with respect to the pace of the economic expansion.

On to Max's questions about the labor markets in a later post.

A side note:  The way I am proposing to think about potential obviously owes a lot to the Nobel-prize winning ideas of Finn Kydland and Ed Prescott.  It also owes a lot to the work of Mike Woodford (and others).  Mark Thoma has been busying himself with explaining this work to blog consumers who care (here and here, for example).  if you are one of them, you will benefit from Mark's efforts.