In particular, it’s self-evident that central bankers need some way of judging the degree of slack in the economy and its effect on prices. If there are either ample underused resources or binding capacity constraints, monetary policy may need to respond pre-emptively. But the concept of the output gap becomes less useful, in my view, if it morphs from being a broad signpost for policy into a de facto intermediate target for policy. If policymakers start to believe that they can steer the output gap towards zero – effectively, to “fine-tune” policy in order to achieve that – they are liable to come unstuck. And our recent experience in the euro area, coupled with my assessment of how the economy is evolving, only reinforces that view. There are three main reasons why I say this. The first is that estimating the output gap in real time is fraught with uncertainty, and the misleading signals this can give to policymakers have been painfully exposed by the crisis. In 2007, real time estimates from a range of international institutions – the European Commission, the IMF, the OECD – envisaged the euro area output gap at that time to be in the range of minus 0.6% to minus –0.2%. According to the most recent estimates, however, we now think that the euro area output gap in 2007 was in the range of plus 2.6% to 3.3%. This shows how wrong real-time estimates can be.
What is clear however is that we have to overhaul our traditional ways of measuring, assessing and reacting to productivity and welfare indicators. Socially, uncertainty will weigh heavily on people’s shoulders in the years to come amid these structural changes. How should policymakers react? The fact that our established gauges have lost their assumed precision does not mean that we have become clueless. In spite of the elevated uncertainty, it is still possible to grasp the obvious. Potential output may not the most reliable benchmark in the current environment. Moreover, perhaps it misses the broader structural changes, which are of paramount importance in the longer run pursuit of improvements in standards of living. So it is crucial that policy makers pay heed to broad and thorough analyses, coupled with an understanding of the limitations to our understanding we face at this time. In this way, modest judgment and prudent action will provide the indispensable preconditions for policymakers to live up to their responsibilities. 6  BIS central bankers’ speeches