Financial output gap - this may be helpful

The key variable to tell us whether we have a overheated economy is looking at the output gap, the difference between actual and trend GDP. The gap has been measured as continuing to be negative so there is plenty of need and room for more aggressive monetary and fiscal policy. There is no overheating is this economy at least by this key measure. However, we may need to also look at the financial sector to tell us something about overheating in the economy.

A financial output gap or adjustment has been developed by some BIS researchers in a piece called, "Rethinking potential output: Embedding information about the financial cycle." A financial output gap measure includes three factors: falling real interest rates, surging credit growth and increases in housing prices. The inclusion of a financial gap can tell us whether both the real and financial sectors have an output gap with the financial gap providing more real-time information.

The graph above shows the output gap as measured the traditional way and the output gap with a financial measure. The left hand graph shows that we were overheated in the pre-2007 period. We may not have known it when comparing the real time versus latest data on output gap measure. In the right hand graph, the researchers included a financial measure which shows that we would have seen that we were overheated prior to the 2008 period. More recently it shows that we have an output that is real and has not improved. There is no potential financial or real overheating in the economy, so there is room for more government stimulus either from monetary or fiscal policies.

There are arguments that the output gap has come down because output measure as have trended lower. This is a complex issue that cannot be easily answered which is one of the reasons that output gap analysis is only suggestive of what may be going on in the economy. However, adding a financial gap can quickly give us another key measure on economic health.