Statement on Monetary Policy – May 20244. In Depth – Potential Output

4.1 What is potential output?

Potential output is the total amount of goods and services that can be produced by an economy that is operating at a ‘sustainable’ capacity.

When the overall demand for goods and services is equal to potential output, the economy is considered to be in balance. At this level of output, factors of production such as labour and capital (which includes the buildings, machines and equipment firms use to produce their goods and services) are being utilised at ‘sustainable’ levels to meet demand, without being underutilised or utilised too intensively. In this context, sustainable means being consistent with low and stable inflation over the business cycle (provided that longer term inflation expectations remain anchored). Over the medium-to-long term, an economy that is operating at its potential level of output is also achieving sustained full employment.^[1]

Australia’s potential output varies over time because of changes in the availability of labour, capital and the growth of productivity. The availability of labour evolves with growth in the overall size of the population and the number of hours each person is willing and able to work when the economy is at full employment. The stock of capital increases or decreases as firms invest in new assets and maintain or retire assets that have depreciated over time. The entire capital stock is not fully utilised all the time, even when output is at potential – for example, machines often require downtime for maintenance, equipment may be sitting idle while waiting to be moved to a different location, and retail and office buildings are typically not in use 24 hours a day. How effectively the economy can use its resources to produce goods and services is another source of change in potential output over time. This depends on productivity growth. When productivity grows, the economy can produce more output even if no additional labour or capital is used. All else equal, productivity growth can reduce inflationary pressure in the short term, as goods and services can be produced more cheaply by using inputs more efficiently.

Longer term economic growth is determined by growth in potential output. Growth in potential output depends on growth in the supply of labour and capital as well as growth in productivity. An important development in recent decades is that the growth rate of potential output appears to have been on a downward trend in many advanced economies, including Australia. This might reflect a number of factors, including slower growth in the labour force, capital stock and productivity. A decline in the growth rate of potential output means the economy cannot achieve the same rates of GDP growth it had in the 1990s and 2000s without putting upward pressure on inflation.

4.2 Why does potential output matter to central banks?

Potential output provides a benchmark to assess the balance of aggregate demand and supply in the economy.

When aggregate demand (as measured by actual output) exceeds potential output, there is a positive ‘output gap’ (Graph 4.1).^[2] When this occurs, factors of production are being utilised intensively to meet demand. While this is feasible in the short run, it cannot be sustained without inflationary pressures rising. Inflation will typically rise above its target, as wage pressures increase in the face of very low unemployment, high vacancies and staff turnover, and as other input costs tend to rise when firms operate their stock of capital intensively and compete for scarce inputs. Once aggregate demand and potential output move closer into balance, inflation will typically move closer to target.

Aggregate demand below potential output (a negative ‘output gap’) often coincides with employment below full employment and capital being underutilised. This is costly in terms of the lost production and consumption from not making full use of Australia’s resources, and in terms of the financial and social costs of employment being below full employment.^[3]

The output gap plays an important role in informing monetary policy deliberations and strategy.

Potential output is not an objective of monetary policy and monetary policy can do little to directly influence it. Potential output is instead determined by technological progress, the stock of capital, investments in innovation and skills, and changes in the size and composition of the workforce. Nevertheless, by maintaining low and stable inflation, the RBA creates the conditions required for sustained economic growth, such as providing the confidence for firms to make longer term investments.^[4]

The output gap is closely connected to price stability and full employment. Monetary policy affects aggregate demand to bring it closer into line with potential output (i.e. closing the output gap); doing so plays a key role in achieving the RBA’s objectives of price stability and full employment.

An output gap close to zero is important in achieving price stability. Deviations of actual output from potential output tend to see inflation deviating from the inflation target. Forming a view on the current and future path of output relative to potential output is therefore an important input into the RBA’s forecast for inflation, which in turn informs the Board’s monetary policy decisions. However, in practice, the output gap is not necessarily the most useful leading indicator for forecasting inflation, and for this reason, measures of labour market spare capacity play a larger role in informing the RBA’s forecasts (see below).

Full employment and an output gap close to zero are interrelated. Full employment is the maximum level of employment consistent with low and stable inflation over the medium term. While this implies a balance between demand and supply in the labour market, low and stable inflation over the medium term also requires balance in the markets for goods and services, and thereby economic activity in line with potential output. Short-term movements of output from potential output tend to coincide with movements of employment from full employment. How the output gap relates to the labour market is discussed in the next section.

4.3 What drives movements in the output gap?

Shocks to demand and supply have different effects on the output gap and potential output.

A range of demand-driven shocks can affect the balance between demand and supply. For example, an increase in foreign demand for Australia’s exports or a rise in government spending increases aggregate demand and so can result in a higher output gap. Excess demand – or a positive output gap – typically warrants tighter monetary policy to ensure output returns to levels consistent with low and stable inflation.

Temporary supply shocks can affect actual output but are not likely to affect potential output. Temporary shocks to the production of goods and services will affect the economy’s supply capacity for only brief periods. As a result, they are less likely to matter for inflation over the medium term. For example, severe weather, such as floods, can temporarily disrupt the domestic production of certain foods. While such events can lead to a shortage of these foods, and put significant upwards pressure on their prices, the effects on the overall productive capacity of the economy are typically not persistent enough to affect potential output over the horizon that is important for monetary policy. That said, a series of temporary supply shocks in one direction that moves inflation away from target for some time could pose the risk that inflation expectations could also drift away from target, which may then become embedded in price- and wage-setting behaviour.

Persistent supply shocks can affect the balance between demand and supply. The pandemic is likely to have had some persistent effects on the trend level of productivity – that is, the level of productivity abstracting from cyclical and temporary factors.^[5] Possible reasons are that firms initially needed to focus more on survival than on growth, firms reorganised their supply chains, and on-the-job learning was disrupted. All else equal, this lowered – for a time – the growth of potential output and so the rate at which demand could grow without putting strain on labour and capital resources. As a result, this generated pressure on inflation.^[6]

Developments on the supply side of the economy can also have implications for aggregate demand. For example, lower potential output that is the result of lower trend productivity growth would feed through into lower expected growth in real incomes (because of higher inflation and/or slower wages growth); lower income growth in turn would mean less demand. This adjustment process tends to take some time to play out, however, and so the output gap may be positive for a time as businesses and households gradually adjust their behaviour. Changes in population growth will also affect both supply and demand for goods and services and so do not necessarily change the output gap. However, rapid growth in the population could have an effect on the output gap because it takes time for the capital stock to adjust. This is particularly relevant for the housing market.

Short-term deviations of actual output from potential output do not always coincide with deviations of employment from full employment.

Full employment and a closed output gap are tightly connected in the medium term, but in the short term, full employment does not necessarily imply a closed output gap. This is because labour is not the only factor of production – whether firms are over- or under-utilising their existing capital can also be important for assessing overall spare capacity and thus inflationary pressure. For example, the ‘mining boom’ saw a substantial rise in the demand for Australia’s commodity exports. While this led to higher demand for both labour and capital in the mining and mining-related sectors, at least for a time capital was in short supply relative to labour. During this period, most estimates of the output gap were higher than suggested by labour market spare capacity alone, until the many large-scale mining investment projects became operational.

However, it is common for short-term imbalances between aggregate demand and supply to be felt across both the markets for labour and for goods and services in a broadly similar way. Short-term movements of employment above full employment usually correlate with an unemployment rate below levels consistent with low and stable inflation – that is, a negative ‘unemployment gap’. Such periods tend to coincide with intensive use of capital inputs and a deviation of output from its potential level. This is a well-documented empirical relationship known as ‘Okun’s law’. While estimates of Okun’s law can be sensitive to modelling assumptions and the precise measures of spare capacity used, and can change over time, the model-based estimate for Australia suggests that a negative unemployment gap of 1 percentage point tends to be associated with a positive output gap of 1¼ per cent, on average (Graph 4.2). In addition to the utilisation rates of capital and labour responding similarly to shifts in aggregate demand, the association in the graph also reflects the fact that labour inputs account for a large share of costs of production in the aggregate economy – that is, the ‘labour’ component comprises a substantial portion of the output gap. But there is still some variation in the relationship, which reflects how the respective gaps do not always paint the same picture about the balance between demand and supply in the economy.

4.4 How do we use these concepts in practice?

A key question for monetary policy is whether the output gap is a useful indicator for forecasting inflation, or whether a narrower focus on spare capacity in the labour market is sufficient.

Conceptually, the output gap is a better indicator of near-term inflationary pressures than measures of spare capacity in the labour market alone, but this might not be the case in practice. The output gap captures imbalances between aggregate demand and supply in the markets for goods and services and therefore the ability of, or need for, firms to adjust prices. However, most of the cyclical variation in output gap measures either comes from, or is strongly associated with, variation in labour market gaps. The unemployment gap also provides more statistical explanatory power for inflation than the output gap in many models of inflation, which could reflect the tendency for labour market gaps to be better measured than output gaps in Australia. Additionally, the official labour market data are available ahead of the data on output, the capital stock and productivity, which makes models based on labour market gaps more useful for forecasting. The RBA’s forecasting framework for inflation includes – along with a number of other important factors such as inflation expectations and costs of labour and other inputs – a combination of labour market gaps and output gaps to capture any differing signals between them.^[7]

Potential output and the output gap cannot be observed directly, they can only be inferred from other information and so estimates are uncertain.

Like full employment, potential output and the output gap cannot be observed directly. The RBA forms its assessment of potential output and the output gap using models, alongside a range of indicators that reflect demand, supply, capacity utilisation and inflationary pressures. Overall, there are fewer indicators of spare capacity in product markets than for labour markets, so our assessment of potential output and the output gap is more reliant on model-based estimates than is the case for full employment and spare capacity in the labour market. The models are also subject to considerable uncertainty, so our assessment of the output gap may be less reliable than our assessment of labour market spare capacity. Our assessments of potential output and the output gap are informed by:

• Model-based estimates: A suite of economic models provide a range of estimates of potential output and the output gap (see below).
• Indicators of capacity utilisation: Survey measures of capacity utilisation and liaison with businesses provide an important read on capacity, including in the more capital-intensive goods-related industries (Graph 4.3). Given the important role of labour market spare capacity, the suite of information used to assess full employment is also an input to the assessment of potential output and the output gap.^[8]
• Activity measures: Measures of aggregate economic activity, in particular GDP, and trends in these measures form a first step of the assessment.
• Inflation outcomes: Changes in the balance between aggregate demand and supply often take time to flow through to inflation – that is, inflation is an important but lagging indicator of spare capacity (Graph 4.3). And, as noted above, some movements in inflation can reflect temporary shocks that are not likely to affect potential output.

No single model or indicator, by itself, is sufficient to assess potential output and the output gap, but taken together they can paint a more complete picture. As such, the full set of information suggests that growth in potential output was subdued during the pandemic and the output gap has been positive in recent years. Even though the level of output (and output per capita) is below the level implied by its pre-pandemic trend, inflation remains above target, and both labour and capital resources are being utilised much more intensively than they were prior to the pandemic. To a large extent this reflects the weak outcomes for productivity growth over recent years, which have weighed on growth in potential output. Providing some offset, there are signs that at least part of the large increase in labour market participation since 2019 reflects a permanent change in behaviour, and thereby has provided some support to growth in potential output. While population growth saw large swings as borders were closed and reopened, the level of the population has returned to be broadly in line with its pre-pandemic trend.

We use economic models to estimate potential output and the output gap.

We maintain a suite of economic models that provide a range of estimates of potential output and the output gap. The suite includes models developed within the RBA, as well as model estimates from third parties such as the OECD (Graph 4.4). Each model has its strengths and weaknesses, so there is no ‘best’ model. Using a range of models and different sources of information helps to inform a more robust assessment given uncertainty about which is the better model. At a high level, all of the models separate short- to medium-term fluctuations in output (i.e. the output gap) from longer run structural trends in economic activity (i.e. potential output). To do this, the models use statistical techniques and economic theory to infer these unobserved concepts from a range of economic data.

Another benefit of a suite of models is that different models can embody different concepts of potential output and provide different insights into how and why potential output is changing. Some of our models – so-called ‘multivariate filters’ – estimate the level of output that would be consistent with low and stable inflation. These models take direct signal from inflation and other economic indicators, particularly GDP and unemployment, to inform their estimate of the output gap. These models could be described as applying a medium-run view of supply, consistent with how central banks, including the RBA, define potential output for monetary policy. Other models take a longer run view, by estimating the level of output achievable if all resources were utilised at their longer run trends. These ‘production function’ approaches focus on structural trends in the underlying factors of production that drive potential output – that is, potential labour, capital and productivity.

Estimates of the output gap are uncertain.

Graph 4.4 shows that central estimates of the output gap differ across models. At each point in time, there are a range of estimates and these sometimes give conflicting indications about capacity utilisation in the economy. Some model-based estimates suggest that there was a significant amount of excess demand in the economy at the end of 2023, while others suggest that demand and supply were close to balance. The wide range of central estimates highlights the uncertainty around making assessments about spare capacity. Each individual estimate is also subject to additional uncertainty not shown in the graph, driven by how well a model fits the data, and further uncertainty occurs in real-time due to data revisions and changes in seasonal patterns. Overall, this justifies using a broad set of information, models and judgement. It also highlights why the RBA is focused on continual improvements in its models and analytic frameworks, to incorporate both new insights and the evolving structure of the economy.

The Reserve Bank Board is attentive to the uncertainty involved in making assessments about the output gap, especially at turning points in the economy. The current level of uncertainty is more elevated than normal due to the unique set of shocks the economy has experienced over recent years. In this environment, it is prudent to regularly interrogate our assessments of the balance between demand and supply in the economy. Our overall assessment of output relative to potential output is included in Chapter 2: Economic Conditions of this Statement, and will be covered in that chapter regularly.

Endnotes

For details on the role of full employment in monetary policy and how it is assessed, see RBA (2024), ‘Chapter 4: In Depth – Full Employment’, Statement on Monetary Policy, February. [1]

The RBA often uses the terms ‘aggregate demand’ and ‘aggregate supply’ (or simply demand and supply) to refer to actual output and potential output, respectively. In this context, ‘aggregate demand’ and ‘aggregate supply’ should not be confused with the quantity of output demanded, or the quantity of output supplied, which should be equal, aside from any changes in inventories. [2]

The experience of many economies after the global financial crisis led to suggestions that demand shortfalls can have very persistent (or even permanent) effects on potential output; see, for example, Ball L (2014), ‘Long-term Damage from the Great Recession in OECD Countries’, European Journal of Economics and Economic Policies: Intervention, 11(2), pp 149–160. [3]

One of the channels through which monetary policy affects economic activity is by affecting how much businesses are willing to invest (in part by affecting demand), which in turn affects the overall stock of capital in the economy. However, these effects tend to be relatively small compared with the overall stock of capital and balance out over the economic cycle. [4]

Productivity is difficult to measure and estimates are volatile, so it is more informative to focus on trend productivity when forming assessments of potential output. The pandemic seems to have disrupted productivity growth for a number of years; the overall weaker rate of productivity growth during this period may result in a lower level of productivity than would have otherwise been the case. [5]

The models were adjusted to take less signal from inflation outcomes between 2021 and 2023 to largely remove supply-driven inflation from measures of the output gap. [6]

For further details on the RBA’s forecasting models, see Cassidy N, E Rankin, M Read and C Seibold (2019), ‘Explaining Low Inflation Using Models’, RBA Bulletin, June; Kohler M (2023), ‘The Why, How and What of Forecasting’, Address to CEDA, Perth, 3 May. [7]

See RBA, n 1. [8]