Signals of continued economic resilience from the output gap

At the July 31 FOMC press conference, Chair Powell said "recent indicators suggest that economic activity has continued to expand at a solid pace," even in the face of a labor market that appears to be normalizing.

Real GDP growth picked up significantly in the second quarter of 2024, according to the BEA's advanced estimate, at an annualized rate of 2.8%. While this output growth is an important measure of activity on its own, many policymakers also pay attention to actual output growth with respect to potential output growth, the economy's estimated maximum sustainable output.

The FRED graph above shows the output gap, which is the difference between actual and potential real GDP. Output has been above potential for the past year; most recently, it appears to have exceeded potential output by about 1% in the second quarter, up from approximately 0.9% in the first quarter. This is an improvement over 2022 and early 2023, when the output gap was slightly negative, and is roughly in line with the second half of 2019, when economic growth was relatively high compared with its 2010-2018 average.

The graph also shows the output gap tends to be negative after recessions, but then eventually returns to a positive gap after a recession. For example, the 2008-2009 financial crisis was deep and long enough to keep actual output below potential all the way through 2017. It wasn't until late 2019 that the gap became firmly positive around levels not seen since 2007.

One signal of the economy's resilience is that output returned to potential within two years of the initial COVID shock in 2020 despite a precipitous decline. Another signal is that the output gap has continued to become positive even as potential output has continued to grow at a stable pace: Annualized quarterly growth rates of potential output have hovered around 2% since 2018. By comparison, growth rates of GDP have averaged 2.8% over the past eight quarters. This also has implications for monetary policy, referred to in this FRED Blog post about the Taylor Rule.

An important caveat: Potential output cannot be observed, so policymakers contend with considerable uncertainty here, including frequent and unpredictable revisions to the estimate of potential output. A good illustration of these revisions over time was delivered by Larry Summers in the 2016 Homer Jones Memorial Lecture.

How this graph was created: In FRED, search for and select "Real Potential Gross Domestic Product." From the "Edit Graph" panel, use the "Customize data" section in the "Edit Line 1" tab to search for and select "Real Gross Domestic Product." You should see two series on the "Edit Line 1" tab listed as (a) and (b). In the "Customize data" section again, enter and apply (b/a - 1) * 100 in the formula bar.

Suggested by Kevin Kliesen and Joseph Martorana.