By Simon Constable

Investors might start hearing a lot more about the output gap, an obscure metric Wall Street professionals historically have used to predict changes in Federal Reserve monetary policy and the potential for an increase in inflation.

Using it, however, can be more art than science.

Put simply, the metric tells us whether the economy is operating near its full capacity. When the economy operates beyond its potential, it tends to overheat, says Win Thin, global head of currency strategy at New York bank Brown Brothers Harriman. "You can grow above trend, but inflation takes off," he says. That's something that typically happens late in the economic cycle when unemployment is low.

The Fed usually raises the cost of borrowing when economic output approaches full capacity to keep inflation in check. That is important to investors because higher rates tend to make securities worth less than they would be otherwise.

It seems unlikely that the Fed will raise interest rates soon. In the second quarter, the economy was operating approximately 10% below potential on a real or inflation-adjusted basis, according to government estimates. That is much worse than the minus 6% gap the U.S. had during the 2007-09 financial crisis.

Based on that data, there would appear to be little risk of the economy overheating and causing inflation.

There are, however, certain drawbacks to using the output-gap metric to predict monetary-policy changes. First, measuring the output gap can be challenging, says Robert Wright, a visiting fellow of policy studies at Georgia College & State University. "There's a lot of difficulty measuring GDP and potential GDP," he says. "Ultimately it's a guesstimate for GDP, and potential GDP is a real guess in the dark, big-time."

What's more, a recent and subtle change in the Fed's inflation target could reduce the output gap's reliability as a predictor of changes in monetary policy even further. Fed Chairman Jerome Powell recently said that the central bank is prepared to let the rate of inflation rise above its 2% target for a prolonged period. But no one at the Fed defined precisely what that means in terms of how high the Fed will let inflation go and for how long.

"I understand what the Fed is doing, but there is no set policy framework," Mr. Thin says. "They will likely err on the side of letting inflation getting too high."

Put another way: When the output gap starts to narrow and the economy reaches its full potential, expect the Fed to allow inflation to rise higher than investors would have previously imagined.

Mr. Constable is a writer in Edinburgh, Scotland. He can be reached at reports@wsj.com.

(END) Dow Jones Newswires

10-04-20 2044ET