The output gap—the deviation of actual output from potential—is a key input into macroeconomic policy decisions, from examining fiscal sustainability to determining the monetary policy stance. For a flexible inflation-targeting central bank for which the monetary policy reaction function includes both price and output stability goals, the policy signal for accommodating output stability depends on the output gap and the evolution of inflation. When the output gap is negative, a loose monetary policy stance is warranted. Conversely, for a positive output gap, a tight monetary policy stance aimed at taming inflation may be optimal. However, real-time output gap estimates are grossly inaccurate and unreliable for policy, largely due to the constant changing output and price dynamics.

With climatic disruptions found to have stronger and more permanent negative effects on output (and the economy as a whole) than previously thought, frequent episodes of climate disasters may induce structural changes in the economy that weaken the relationship between inflation and output dynamics, further complicating the task of distinguishing signal from noise in the estimation of potential output.

Using mean temperature and precipitation ‘anomalies’ as proxies for climatic variations over time in selected countries, Augustus Panton employs a multivariate filtering model estimated by the data-driven Maximum Likelihood technique in the state-space context to derive climate-neutral measures of potential output and output gaps. The results show that potential output and output gap measures that are adjusted for climatic disruptions are more accurate in real time than those obtained from conventional approaches that do no take climate effects into consideration.

Augustus Panton is a PhD candidate in Economics at CAMA in the Crawford School of Public Policy. He is a Teaching Assistant at the ANU Research School of Economics where he was recently awarded the 2018 Excellence in Tutoring Award and also an ARC Centre of Excellence in Population Ageing Research (CEPAR) affiliated research student. His PhD research focuses on the joint design of monetary policy and climate policy regimes towards optimal macroeconomic stabilization in an environment characterized by climatic disruptions and heightened financial stability risks.

Prior to joining ANU, Augustus worked as Economist at the Central Bank of Liberia. Before then, he worked with several other public service institutions, including the Liberian Ministry of Finance & Development Planning and the Ministry of Commerce & Industry. He has provided consulting services, at various times, for the International Finance Corporation/World Bank, the Brookings Institution and the ECOWAS (Economic Community of West African States) Commission.

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