Reading the Stars

IMF Working Papers, July 24, 2020

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Following the global financial crisis, significant uncertainty has existed around the U.S. economy’s steady state equilibrium.
The paper uses a factor model to provide a new approach to estimating “the stars” (i.e. the neutral interest rate, maximum employment, and the level and growth rate of potential output) that are most consistent with a medium-term equilibrium where inflation converges to the FOMC’s two percent target.
The approach is applicable to any country with an inflation targeting central bank.
The model explicitly incorporates estimates of the extensive margin of slack in the labor market, which has proven to be an important factor in describing the post-financial crisis landscape.

Uses a factor model to estimate latent equilibrium variables (“the stars”).
Targets a medium-term equilibrium characterization where inflation converges to the FOMC’s two percent target.
Explicit incorporation of the extensive margin of labor market slack into the estimation framework.

The factor-model approach yields estimates of:
- the neutral interest rate,
- maximum employment,
- the level and growth rate of potential output,

that are consistent with inflation converging to the FOMC’s two percent target.

Including the extensive margin of labor market slack is important for describing post-financial crisis dynamics.

Applicable to any country with an inflation targeting central bank.
Focus primarily on the U.S. economy in the context of post-global financial crisis uncertainty.

Subject: Business cycles, Inflation, Inflation targeting, Output gap, Productivity
Keywords: inflation expectation, inflation gap, output gap estimate, output gap estimation certainty, PCE inflation, WP