Unobserved components model(s): euro area output gaps and financial cycles

Assessing the stage of the financial cycle has become an established element of policy analysis, when evaluating the cyclical position of the economy. This paper examines whether including financial variables enhances euro area output gap estimation and its cyclical properties. While financial variables may, in principle, help capture financial imbalances that precede economic downturns, the empirical gains from their inclusion remain limited and uncertain. This paper presents a suite of output gap estimates incorporating financial variables, based on both small unobserved components models and a large unobserved components model that follows a production function approach. The results show that financial variables, which co-move strongly with the output cycle, can sometimes improve output gap estimates. However, these improvements are modest in magnitude, sensitive to the choice of financial variables, and more pronounced at the country level than at the euro area aggregate.