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Source: Bloomberg Source: Bloomberg

Revisions to the U.S. gross domestic product since 2011 reinforce the shift to a slower era of economic growth and underscore the difficulties the Federal Reserve faces in gauging just when to inch interest rates away from the zero-lower bound.

According to the Bureau of Economic Analysis, real GDP from 2011 to 2014 increased at an annual rate of 2 percent, a downgrade from the prior estimate of 2.3 percent.

The Fed's July statement, meanwhile, indicated the central bank will raise rates when it has seen "some further improvement in the labor market" and is "reasonably confident" that inflation will trend toward 2 percent.

During the press conference following the Fed's June statement, Janet Yellen made a reference to the role that the output gap—the cumulative difference between estimates of how much the economy can grow and how much it has actually grown—plays in the formation of monetary policy.

"I think we need to see additional strength in the labor market and the economy moving somewhat closer to capacity—the output gap shrinking—in order to have confidence that inflation will move back up to 2 percent," she said.

Since potential growth cannot be observed directly but only estimated, economists typically turn to other indicators, such as inflation and unemployment, to get a sense of just how much excess capacity exists.

When the economy endures a negative shock, as seen during the financial crisis, it requires monetary stimulus to expand at an above-potential rate and thereby eliminate the economic slack that became abundant during the downturn and foster a pickup in inflation.

In theory, setting interest rates to keep actual growth close to potential will enable the Fed to achieve both parts of its dual mandate: price stability and full employment.

But the slower growth since 2011 revealed on Thursday means that either the U.S. still has much room to grow before all the crisis-induced damage has been repaired and inflationary pressures arise, or that the Fed has been overestimating just how fast the U.S. economy is able to expand.

Economists believe that the latter is true—that the top speed for the U.S. economy has come down by more than previously thought.

"The latest numbers suggest that potential growth has been even slower than the cool numbers we've been looking at," says Avery Shenfeld, chief economist at CIBC World Markets.

"Measuring an output gap at this point in history is extremely difficult," says Ethan Harris, co-head of global economist research at Bank of America. "The economy just went through a big crisis with a lot of structural damage."

Harris suggests that the mix of data received this morning—slower growth coupled with a faster than anticipated 1.8 percent rise in the personal consumption core price index—might make the Fed marginally more hawkish.

"Potential GDP growth is probably only around 1 percent," adds Deutsche Bank chief U.S. economist Joseph LaVorgna, who believes the central bank will raise rates in September. "The Fed is playing a dangerous game of keeping policy super loose and trying to find out where that output gap closes."

LaVorgna also indicates that slower potential growth cuts both ways for the bond market. On the one hand, it entails a lower equilibrium interest rate, which would be positive for fixed income. On the other hand, it means that the economy currently has much less slack now, bringing the Fed closer to rate hikes, which are generally bad for bonds.

And while the output gap is useful from a conceptual standpoint, LaVorgna says, the difficulties associated with tracking it in real time, which requires guesswork on estimated productivity growth, make it an impractical metric for monetary policymakers to use.

"You only know what slack is after the fact," he says.

Today's revisions are a case in point: Without offsetting downgrades to potential growth, the revised figures roughly double the size of the output gap, based on recently published estimates from the Federal Reserve Board's staff.

A widening output gap would be at odds with continued improvement in the labor market, which Harris sees as a better gauge of how close the economy is to full potential.

"I'd be more inclined to look at the labor market where you've got cleaner data and look for corroborating evidence from wages," says Harris. "If I'm the Fed, I'm not going to try to push for stronger growth. I'm willing to accept a slower trend."