Running blind
FOR MOST central bankers, the output gap is a compass. It tells them whether the economy is overheating or slumping and whether to tighten the screws or loosen them. In rich countries the conversation about this gap is technical: about unobserved components, multivariate filters, the eternal debate over the NAIRU (non-accelerating inflation rate of unemployment). In Nepal the conversation begins with the weather. A paper from the country’s central bank, Nepal Rastra Bank, confirms just how different the task of macroeconomic management looks when the most important variable is not the Taylor rule but the timing of the monsoon.
The paper, produced by the bank’s research department, estimates Nepal’s potential output—the level of sustainable, non-inflationary growth—and the output gap that opens and closes around it. Over the four decades to 2017, potential output grew by just 4.1% a year on average. That is a meagre number for a poor country trying to climb the income ladder.
More striking is what has happened to total factor productivity, the measure of how efficiently an economy uses its capital and labour. Productivity growth was feeble in the 1980s, ran at about 0.5% in the 1990s and 2000s, and has turned negative since 2011. An economy cannot grow rich on capital accumulation alone. Without better productivity Nepal’s potential will stay stuck.
Yet the paper’s most illuminating finding is what makes actual output deviate from it. In developed economies output gaps are typically demand-driven: a burst of consumer spending or a collapse in investment, say. In Nepal the gaps are supply-driven and follow a rhythm obvious to any farmer. The authors find that the output gap correlates closely with the monsoon cycle, which repeats roughly every four years. A favourable monsoon produces a positive gap; a drought produces a negative one. The largest negative gap in the sample, -4% in 1980, came after a severe drought. The largest positive gap, 2.1% in 2001, followed favourable weather and the commissioning of a large hydropower project. More recently, the devastating earthquake of 2015 and the subsequent border blockade pushed the gap to -2.5% in 2016.
This is not the stuff of typical central banking manuals. Monetary policy in such an environment becomes a blunt instrument. If the economy is below potential because the monsoon has failed or a border has been closed, cutting interest rates will not bring rain or reopen trade routes. The paper’s authors note that the volatility of the output gap has moderated since the 1980s, but the underlying drivers have not changed. The economy remains hostage to forces outside the control of any central banker.
What makes the situation more complex is that even when demand-side policies might help, the tools to deploy them are underdeveloped. The output gap was close to zero in the years after the global financial crisis, but not because of skilful macroeconomic management. It was because a succession of shocks—political instability, supply disruptions—kept the economy in a state of near-permanent adjustment. The paper’s estimates from a production-function approach, which tries to account for the actual factors of production, show that the negative gap narrowed in 2017. That suggests a recovery. But it is a recovery built on fragile foundations.
For policymakers, the implication is nasty. In most countries the output gap is a signal for countercyclical policy. In Nepal it is a reminder that the tools of countercyclical policy have limited purchase. The paper points to what might raise potential output in the long run: boosting total factor productivity through trade openness and stability in the real exchange rate. But those are structural fixes, not the sort of thing a central bank can achieve in a quarterly meeting.
The authors are careful to note the limitations of their data—annual figures only, a relatively short time series—but the bigger point stands. For an economy still heavily agricultural, where a quarter of GDP can swing on the rains, the output gap acts more as a weather vane than a compass for policy. It tells you which way the wind is blowing. It does not tell you how to change it. ■
