Can inflation data improve the real-time reliability of output gap estimates?

Potential output plays a central role in monetary policy and short-term macroeconomic policy making. Yet, characterizing the output gap involves a trend-cycle decomposition, and unobserved component estimates are typically subject to a large uncertainty at the sample end. An important consequence is that output gap estimates can be quite inaccurate in real time, as recently highlighted by Orphanides and van Norden (2002), and this causes a serious problem for policy makers. For the cases of the US, EU-11 and two EU countries, we evaluate the benefits of using inflation data for improving the accuracy of real-time estimates.