@matthewklein and the rest of the talented team over at FT Alphaville have been doing a series of posts covering the release of transcripts from the Fed's 2009 meetings. While most of the coverage has been great, one sentence struck me as...well, just plain wrong.
Quoth Matt:
Matt is saying - unless there was some drastic oversimplification and editing in the piece - that there are no resource constraints in an economy. That is to say: if potential GDP was not a valid construction, then there's no theoretical limitation on how fast the economy could grow while prices remained stable. This is ludicrous at its face; is it possible that the total value of goods and services produced in the US economy next year could be twice that of this year, with no inflation? As with all things, as demand (growth) accelerates, supply has to catch up and the friction is inflation.
Now, I'm quite sympathetic to the view that over time potential GDP is extremely hard to quantify - ex ante - and that its drivers (constraints on labor supply, resource scarcity, investment shortages) are not constant over time either. For example, "potential" GDP growth in the 1960s was clearly higher than in the 1970s, as steady-state real growth was in the neighborhood of 5% while inflation hung out below 2%. In the 1970s, oil price shocks, supply-side inefficiencies and other issues without question lowered the total output capacity of the economy relative to trend, therefore lowering potential output.
Of course, the Fed's models don't capture this.
Edit: The above chart shows the level of GDP and potential GDP, not its growth rate. Therefore "growth" in the note is incorrect. Rather, low growth leading to output below potential in terms of level is the correct way to describe it. h/t @barnejek.
So I'm not here defending the Fed's models! Rather, I'm defending the abstract concept. I do think Matt is correct to critique its use, I just don't think "it's bogus" is the right way to dismiss it. I'd have rather seen something like "a theoretically legitimate concept that is hard enough to apply in practice that it shouldn't be given too much weight". Like other absolute concepts like NAIRU (non-accelerating inflation rate of unemployment), potential GDP shouldn't be thought of as a line in the sand, but instead as a probability distribution; as unemployment drops and nominal growth accelerates, the probability of accelerating inflation itself accelerates; it doesn't become some sort of inevitability.
