Pitfalls in monetary policy decisions based on the output gap

In many countries monetary policy decisions are based on the output gap. In particular, monetary easing is usually justified by citing slack in the economy. However, the use of subjective information can result in an inaccurate estimate of the output gap, and its partial interpretation can lead to a wrong monetary decision. This paper establishes that monetary decisions can be inconsistent when they are based on an output gap estimated with the HP filter with tail correction and when policymakers assume that a negative gap does always indicate weakness in demand. We suggest that monetary policymakers should use several methods and approaches, with the purpose of taking decisions with the most complete and accurate information available.