An assessment of the relative quality of the Output Gap estimates produced by the EU’s Production Function Methodology

Summary:

This paper assesses the performance of the EU’s production function (PF) methodology for estimating output gaps since its introduction in the EU's policy surveillance procedures in 2002. It looks at how the methodology has performed relative to the method used up until 2002 (i.e. the Hodrick Prescott filter), with respect to its ability to track the euro area's business cycle. It also compares the PF method with the equivalent OECD and IMF methodologies in terms of its stability, real-time reliability and financial crisis performance.

The analysis shows that the EU's PF method has performed better than the HP filter and the equivalent OECD & IMF methods. The results consequently strongly support the 2002 ECOFIN Council decision to adopt the PF method as the EU's ‘commonly agreed’ reference method. Nevertheless, whilst the PF method has clearly done well in relative terms since it was first introduced, the analysis also recognises the absolute size of the output gap errors made by all of the methods in the pre-crisis period. These errors underline the importance of continuing to improve the EU’s commonly agreed methodology, with a particular focus on attenuating procyclicality risks in the upswing phase of the business cycle.

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