Measuring the Euro Area Output Gap

TL;DR

This paper estimates the Euro Area's output gap and potential output using a non-stationary dynamic factor model, revealing that the economy was often tighter than institutional estimates suggested, with implications for inflation dynamics.

Contribution

It introduces a novel non-stationary dynamic factor model to measure the Euro Area output gap using extensive macroeconomic and financial data.

Findings

Euro Area was often tighter than institutional estimates from 2012 to 2024.

Decline in trend inflation kept core inflation below 2% pre-pandemic.

Demand forces contributed at least 30% to post-pandemic core inflation rise.

Abstract

We measure the Euro Area (EA) output gap and potential output using a non-stationary dynamic factor model estimated on a large dataset of macroeconomic and financial variables. Our results indicate that, between 2012 and 2024, the EA economy was consistently tighter than suggested by institutional estimates, implying that its weak growth reflects a potential output problem rather than a business-cycle one. Moreover, we find that the decline in trend inflation-rather than economic slack-kept core inflation below 2% before the pandemic, while demand forces explain at least 30% of the post-pandemic rise in core inflation.