Where are We Headed? Perspectives on Potential Output Patrick Blagrave, Mai Dao, Davide Furceri (team lead), Roberto Garcia-Saltos, Sinem Kilic

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1 Where are We Headed? Perspectives on Potential Output Patrick Blagrave, Mai Dao, Davide Furceri (team lead), Roberto Garcia-Saltos, Sinem Kilic Celik, Annika Schnücker, Juan Yepez, and Fan Zhang, and with support from Rachel Szymanski

2 Six years after the GFC, output remains below precrisis expectations Fall 7 Fall 8 Fall 4. World. Advanced Economies 3. Emerging Market Economies Note: The index is created using real GDP growth rates and their WEO forecasts.

3 and growth expectations have been steadily revised down 8 Fall Fall Fall 3 Fall World Advanced economies Emerging market economies Note: WEO medium-term growth projections are five-year-ahead growth forecasts. 3

4 Questions Before the crisis: how did potential output and its components evolve from the mid-99s until the crisis? Looking at the Crisis: what happened to potential growth during the crisis? Looking Forward: where potential growth is headed? 4

5 Potential Output: A Primer

6 Estimating potential output Definition of potential: output without inflationary or deflationary pressures Estimates of potential output using multivariate filtering techniques: Simultaneous Equation Model estimated with Bayesian methods: Stochastic process for output and the NAIRU; Phillips Curve; Okun s relationship Observables (GDP, inflation, unemployment)and expectations: - year ahead GDP growth expectations and - year ahead inflation expectations from Consensus Economics. Sample: unbalanced of AEs-G and 6 EMs-G from the mid-99s to Advanced economies: Australia, Canada, France, Germany, Korea, Italy, Japan, Spain, the United Kingdom and the United States Emerging Market Economies: Brazil, China, India, Mexico, Russia, Turkey 6

7 Potential growth accounting decomposition Estimates of potential growth from the multivariate filter are decomposed as follows: y = a + α n + ( α) k where n is potential employment; k capital; a trend TFP (estimated as a residual) Potential employment growth is decomposed into changes in NAIRU participation rates l and working age population ( p) : u, trend Sources: n = u + l + p Capital from OECD NAIRU obtained from the MVF Working age from UN Trend participation rates from cohort model 7

8 Before the Crisis

9 Potential growth was declining in AEs but increasing in EMs. G6. Advanced Economies 3. Emerging Market Economies Emerging market economies Emerging market economies excluding China

10 AEs: lower TFP growth and to a lesser extent lower potential employment growth (aging) 3.5 Total factor productivity growth Capital growth Potential employment growth Potential output growth.9 %.5.5 %.7 %.5 %.8 %.5.8 % Note: LFPR = labor force participation rate; and NAIRU = non-accelerating inflation rate of unemployment.

11 EMs: higher TFP growth and to a lesser extent capital growth 8 Total factor productivity growth Capital growth Potential employment growth Potential output growth 6 4. % 3. % 4.9 %.9 %.6 %.6 % Note: LFPR = labor force participation rate; and NAIRU = non-accelerating inflation rate of unemployment.

12 During the Crisis

13 AEs: potential growth declined by about ½ percentage point, due to lower capital and potential employment growth Capital growth Potential employment growth Total factor productivity growth Potential output growth. Advanced Economies. United States 3. Euro Area

14 AEs: the decline in potential employment growth attributable to demographic factors NAIRU Working-age population LFPR due to aging LFPR excluding aging Potential employment growth. Advanced Economies. United States 3. Euro Area E Note: LFPR = labor force participation, and NAIRU = nonaccelerating inflation rate of unemployment. 4

15 EMs: potential growth declined by about percentage points, due to lower TFP growth Capital growth Potential employment growth Total factor productivity growth Potential output growth. Emerging Market Economies. China 3. Emerging Market Economies Excluding 8 China

16 Where are We Headed?

17 What is the likely trajectory of potential output in the medium term (5-)? Answering this question requires some conjecture about prospects of its main components: Potential employment growth (demographic projections next slide) Capital growth (Investment-to-capital ratios stable at current levels) TFP growth (evolves in line with to pre-crisis rates in most economies) Large uncertainty surrounding the analysis 7

18 Potential employment growth is expected to decline in both AEs and EMs due to aging Labor force participation rate due to aging Working age population Net effect of demographics..8. Advanced Economies. Emerging Market Economies 3. Emerging Market Economies.4..5 Excluding China E

19 Putting it all together AEs: Potential growth remains below precrisis rates. EMs: Potential growth declines further.. Advanced Economies. Emerging Market Economies Total factor productivity growth Potential employment growth Capital growth Potential output growth Total factor productivity growth Potential employment growth Capital growth Potential output growth

20 Implications Implications for fiscal and monetary policy Harder to maintain fiscal sustainability and rebuild fiscal buffers Zero lower bound in AEs may re-emerge In some economies living standard may expand more slowly Increasing potential output a priority AEs: demand support to tackle weak investment and structural unemployment, policies and reforms to boost productivity, infrastructure capital and labor supply EMs: policies and reforms directed at removing critical bottlenecks, improving business conditions, and boosting participation rates and educational attainment

21 Where are We Headed? Perspectives on Potential Output Patrick Blagrave, Mai Dao, Davide Furceri (team lead), Roberto Garcia-Saltos, Sinem Kilic Celik, Annika Schnücker, Juan Yepez, Hongyan Zhao and Fan Zhang, and with support from Rachel Szymanski

22 MVF estimates of potential growth

23 Quasi real-time revision properties