Output Gaps and Cyclical Indicator

Questions have recently been raised on the usefulness of output gaps (which define the cyclical position of a country) for policymaking purposes. Whilst these questions are important in raising awareness concerning the uncertainty which inevitably surrounds an unobservable variable such as the output gap, we believe that the discussions are sometimes neglectful of the empirical evidence with respect to the performance of specific business cycle indicators. The current article therefore assesses the empirical performance of the most widely used business cycle indicators in output gap analysis, with a significant proportion of the recent criticism on the economic plausibility of output gaps drawing heavily on specific inflation indicators (such as headline or core inflation) or on indicators of external imbalances. The empirical evidence in this article shows that these inflation and external balance indicators do not perform well as indicators of the cycle and consequently should be used with caution by policy makers.