Real GDP Growth Predictability and Implications for Estimating Australia’s Output Gap

The output gap, defined as the cyclical component of real GDP, is a key variable for macroeconomic policy. It is also sometimes analogously interpreted as a measure of the business cycle. Real GDP growth in Australia has been known to be almost unpredictable beyond a constant level using standard time series models of its own past outcomes. We discuss some of the implications of this lack of predictability and what it implies for estimating the Australian output gap. In particular, it has long been recognised that a lack of predictability in the underlying growth series can lead to estimating spurious cycles in levels. On a more positive note, we show that there may be useful forecasting information for output growth in other variables, in particular those associated with the foreign sector. This provides useful context for a small open economy such as Australia and suggests that methods to estimate the Australian output gap may benefit from building models to utilize such information.