Judging post-COVID economic recoveries

Comparing output gaps across countries, the US stands out with key measures of activity back in line with their pre-COVID trends, pointing to a higher neutral policy rate. Australia is in second place, suggesting that the RBA’s focus on weak consumer spending is overdone. Japan’s moderately large output gaps suggest the withdrawal of policy stimulus should be slow. The euro area, the UK, and NZ all have significant output gaps. This helps explain the dovishness of ECB and BoE policy-makers, although the RBNZ views rate cuts as a distant prospect as it weighs up whether potential growth is lower than prior to the pandemic.

How does the post-COVID economic recovery shape up across countries? 

Adapting and extending some Fed analysis, the charts below compare three different measures of activity – namely, GDP, consumer spending, and domestic demand* – with their pre-COVID trends, approximated using simple linear estimates, for a number of advanced economies.

The gaps between these three measures of activity and their simple trends are all versions of the output gap, which compares output with its estimated potential. 

Central banks usually rely on measures of slack in the labour market to forecast inflation because labour market statistics are more timely and much less susceptible to revisions, but they still track different versions of the output gap.

Most central banks focus on the GDP measure of the output gap, but some of them emphasise consumer spending because it accounts for the bulk of activity in most countries. 

Less commonly, central banks emphasise domestic demand, which is the total of private- and public-sector spending and investment. 

The RBA is currently fixated on consumer spending, although it sometimes highlights domestic demand instead.

As shown in the charts below:

• Economic recovery has been strongest in the US, with GDP and domestic demand both back in line with their pre-COVID trends and consumer spending 1% above its simple trend.
  
  
• Australia’s recovery has actually been close behind, with output in line with its pre-pandemic trend, consumer spending 3% below, and domestic demand 2% above.
  
  
• Japan is middle of the pack, with output, consumer spending, and domestic demand all 3% below their respective pre-COVID trends.
  
  
• The euro area, the UK, and New Zealand are all well below their pre-pandemic trends for the three indicators, although note that New Zealand numbers for consumer spending and domestic demand are of lower quality (Brexit has also likely contributed to the UK's poor performance).  

Mindful that the estimated gaps should be taken with a grain of salt given their simple construction, particularly for the euro area given its labour market is yet to reflect the sustained weakness in activity, the implications for policy are:

• The resilience of US activity plays to the theme that the neutral policy rate is likely higher than its pre-COVID trend, which should limit eventual rate cuts. After all, it is hard to justify aggressive rate cuts rates if the economy holds up.
  
  
• In Australia’s case, the RBA’s focus on consumer spending seems overdone, partly because GDP and domestic demand tell a different story, but also because consumer spending is likely to pick up now household income is past its worst point and given strong growth in house prices (less importantly, note that the ABS counts directly subsidised household expenditure on rent/utilities/child care as public rather than private spending, with much larger-than-usual subsidies over the past couple of years).
  
  
• Japan recently started to edge away from emergency settings for monetary policy and further withdrawal of stimulus could be a very drawn-out process.
  
  
• The large output gaps in the euro area and UK help explain the ECB and BoE’s signalling that lower interest rates are likely this year. The same doesn’t hold for the RBNZ, which remains hawkish and is forecasting a delayed easing cycle as it weighs up whether potential growth is lower post COVID because of poor productivity, such that spare capacity could be much less than suggested by the simple linear trends.

More generally, the presence of large output gaps in the euro area, the UK, and New Zealand two to three years after the worst of the pandemic suggests that COVID has had a more lasting effect on both activity and probably its trend. 

This is unusual, as persistently large output gaps normally follow a banking crisis, as was the case in many countries after the global financial crisis (see the last panel of charts).

Note:
* Domestic demand was approximated by GNE, which is demand plus the change in inventories, for the euro area, UK, and New Zealand. Euro area GNE was proxied by Germany, France and Italy.