Federal Reserve Board research develops new euro area potential output and output gap estimates pointing to structural growth weakness

The Federal Reserve Board published a FEDS Note introducing new estimates of euro area potential output and the output gap using a non-stationary dynamic factor model built on a large set of macroeconomic and financial indicators. The analysis concludes that the euro area’s weak growth performance is primarily a potential output problem rather than a business cycle problem, implying that demand stimulus would have only short-lived effects relative to supply-side reforms with long-run impact. The model is estimated on 119 euro area indicators spanning 2001:Q1 to 2023:Q4 and is run with an explicit adjustment for Covid-related level shifts and volatility before re-estimation on the full sample. Results indicate that potential output growth slowed after the 2008–2009 global financial crisis and slowed further following the 2011–2012 sovereign debt recession, while Covid had only a transitory effect on potential growth. By end-2023, potential output growth is estimated to remain below its pre-crisis pace and the output gap is estimated at about 3 percentage points above potential. While turning points in the output gap align with European Commission and IMF estimates, the note’s measure signals a tighter economy after the sovereign debt recession, hovering around 2% from 2017 to the pandemic, with labour market, inflation, and financial indicators, particularly household liabilities, playing a key role in the cyclical assessment and in illustrating the unsustainability of debt-financed growth.