The answer to this question is important to determine the appropriate policy mix and sequencing of supportive macroeconomic policies and structural reforms to lift growth.
Estimating potential output is even more challenging for emerging economies. That is due to major structural shifts in South East Europe (SEE) economies, including financial deepening, and short time series with just one boom-bust cycle for many of these countries.
A large share of the post crisis growth slowdown in SEE countries was sustained. The potential output growth slowed down by about 2 percentage points after the crisis compared with pre-crisis years, which accounts for about half of the total growth slowdown.
Post crisis potential growth was dragged down mainly by stagnant total factor productivity (TFP) and, to a lesser extent, slower capital accumulation. However, given the uncertainty surrounding estimates of TFP, which is measured as a residual, further analysis is needed to understand what has been driving the TFP slowdown. The region-wide slowdown in potential growth has been associated with common external factors, which among other things may reflect trading partners’ potential growth as well as the evolution of global trade and global supply chains. For some countries, negative demographics have also played a role in holding back potential growth.
The differences of potential growth estimates based on different methods are generally small, reflecting overlapping information sets used by different methods and the interconnectedness of real and financial sectors of the economy, which results in similar signals from real and financial variables. Differences arise when synchronization between the real and financial cycles is low, which in part, may reflect the presence of financial frictions and real economy rigidities.
Given the significant slowdown in potential growth, the post crisis growth rebound in the Albania suggests a gradual narrowing of the negative output gaps, which appear largely, closed in 2015 for much of the region. This is consistent with the gradually dissipating disinflationary pressures in non-tradable sectors that are more directly linked to domestic demand and with declining unemployment rates, while headline inflation remained low on falling import prices, notably energy.
Potential output growth in SEE countries, as well as in Albania has been largely associated with trading partners’ potential growth and other common factors. Owing to imported low inflation and appreciably lower oil prices, the headline inflation may be masking emerging domestic inflationary pressures. Wage inflation and non-tradable services inflation however, suggest dissipating disinflationary pressures, which is consistent with falling unemployment rates and increasing capacity utilization. Core inflation in most of the region is still considerably below inflation targets. In the environment of a still sluggish global recovery, boosting potential growth in SEE may be particularly challenging.
Well-targeted structural reforms are needed to raise potential growth. At the same time, expansionary fiscal and monetary policies by boosting employment and demand could help mitigate potential hysteresis effects and support structural reform in lifting potential output.
In addition, some countries like Albania, Kosovo, and Bosnia may need to use active labor market policies to increase labor force participation and mitigate the negative impact of shrinking labor force on potential growth.