If in turn a policy reaction function depends crucially on such unobservable variables, errors in assessing the size of those variables may lead to large deviations from optimal policy. As empirical studies show, this applies in particular to a policy rule of the Taylor type, which places a relatively large weight on the output gap.
Orphanides and others have shown that in the seventies and eighties, estimates of the US output gap have been subject to large and persistent measurement errors.8 On average, there has been a downward bias of this measure of economic activity which in turn led to a monetary policy of the Fed that - with hindsight - must be judged as too expansionary.