Estimating the output gap in real time: A factor model approach

•We use a dynamic factor model to estimate U.S. real time output gaps.•This reduces substantially the errors in the gap due to data revisions.•We then augment the data with forecast from our model prior to filtering.•This reduces the end-of-sample imprecision on the gap estimate.•The increased precision has economic importance for real time policy decisions and improves real time inflation forecasts.

By using a dynamic factor model, we can substantially improve the reliability of real-time output gap estimates for the U.S. economy. First, we use a factor model to extract a series for the common component in GDP from a large panel of monthly real-time macroeconomic variables. This series is immune to revisions to the extent that revisions are due to unbiased measurement errors or idiosyncratic news. Second, our model is able to handle the unbalanced arrival of the data. This yields favorable nowcasting properties and thus starting conditions for the filtering of data into a trend and deviations from a trend. Combined with the method of augmenting data with forecasts prior to filtering, this greatly reduces the end-of-sample imprecision in the gap estimate. The increased precision has economic importance for real-time policy decisions and improves real-time inflation forecasts.