Inflation Part 2. The Real GDP Gap

Last week I tried to explain why I am not a big fan of the Phillips Curve. If you were not bored by that little detour then maybe you won’t fall asleep this time either. We in the USA are clearly thinking about inflation these days. Is it going to come back and scare the bejeezers out of us? Or not. Since my crystal ball is at the Hyundai place for its 30,000-mile service, I won’t regale with you with any forecasts. But I will pull out some data that I think is pretty interesting with regard to inflation. To give away the ending -- it is not easy to see a 70s style inflation roast.

Last week I punched at the Phillips Curve and concluded it was a fake for the real thing – a supply and demand analysis of inflation. Since supply and demand puts most people to sleep, I decided that I would use a close cousin called the real GDP gap. The real GDP gap measures the difference between actual output and something we call potential real GDP. Remember when you were a little kid and they said you had the potential to be the next Liberace? You were not yet the equal of Liberace and probably were not even equal to Elton John. But they thought that you had a lot of potential. Potential real GDP is similar in that it is not what we actually produced but is a measure of what we are capable of producing (if all of us were working).

When we subtract actual GDP from Potential GDP we get a gap that is a measure of how far off from potential we are. If that gap is very large, then we would be saying that demand is not strong enough to lead to output equal to our potential. That is the kind of time when prices and wages are not growing very fast. But if real GDP is a lot higher than real potential GDP, then we have a gap that represents a lot of demand compared to what we can usually produce. During those times we produce more than potential output because more of us are out of the house and into jobs! These time periods are not sustainable because most of us don’t like to work that much all the time and because it often causes inflation.

Today I look at those historical time periods in which output was a lot higher than potential real GDP. It turns out that since 1960 we have had six of those episodes. The table at the bottom contains information for those six and for the seventh one that just recently started near the end of 2017. Since the latter has lasted only three quarters, it ain’t much to look at. But those three quarters make us wonder if this will be like any of the past six time periods when real GDP exceeded potential.

The six episodes were as short as three quarters (1989) and as long as 24 (1964). The average time was about 11 quarters or just short of three years. Based on these almost 60 years of experience in the USA, output has a tendency to be higher than potential for just about three years at a time.

How much output was above potential varies too. During the 1964 episode, output started out a tiny bit above potential (0.7%) and was as high as 5.6% greater than potential during one of those quarters. It averaged about 2.6% above potential over those 24 quarters. This shows it is possible for real GDP to grow very rapidly relative to its potential. Only in the 1972 episode did output again show such strength when it averaged 2.3% above potential. Since 1978, we have very few cases of real GDP being 1% above real GDP.

What about the inflation rate? In five of the six episodes, the inflation increased. In the 24 quarters from 1964 to 1969, the inflation rate rose by 3.2 points, from 1.5% to 4.7%. In the next time frame, it increased by 6.7 points as it went from 3.3% to 10% in the early 1970s. Of course you could say the inflation rate tripled in both of those time periods.

Notice that the inflation rate responded heartily to gaps through 1980 but much less thereafter. This mostly reflects that gaps became smaller but might also question the response of inflation to any given gap.

            Change in the Inflation Rate

            From Beginning to End of Period

            1964-1969     3.2

            1972-1974     6.7

            1978-1980     4.2

            1989-1989   -0.4

            1997-2000     1.3

            2006-2007     0.3

            2017-2018     0.3

Nothing is proved here. But clearly it will take a while before we can say anything about how much inflation will rise in the coming years. If the growth rate of real GDP does not pick up substantially in the next years it is hard to see how a gap analysis would yield a large change in the inflation rate. If the inflation rate is close to 2% right now, then should we be worried about it rising much beyond 3%? If so, would that be a disaster? If not the gap, then what else might cause inflation to rise in the coming years? 

Table: Gap and Inflation

                           GAP*                Inflation Rate**

1964:1    0.7  5.6  0.5  2.6      1.5   4.7   4.7  3.2

1969:4          

1972:2    1.6  4.3  0.6  2.3      3.3 10.0  10.0  6.7

1974:2

1978:2    1.8  2.3  0.1  1.3      6.8  11.0 11.0 4.2

1980:1

1989:1    0.2  0.2  0.2  0.2      4.5   4.1  4.1 -0.4

1989:3

1997:2    0.3  2.0 0.7  0.9      1.8  2.5   2.5  0.7     
2000:3

2006:     0.5  0.4  0.4 0.2       3.0  3.3  3.3   0.3

2007:4

2017:    0.2  0.7  0.7  0.5      1.5  1.7  1.8   0.3

2018:1

 *Gap is the percentage that the actual GDP is above potential GDP. The four numbers represent that % gap during the first quarter, the highest quarter, the end quarter, and the average of all the quarters in that time period

** Inflation is measured by the annual change in the Personal Consumption Expenditures Deflator in that quarter relative to the same quarter in the year before. The four numbers reflect the measurement in the first quarter, the highest quarter, the end quarter, and the change from the beginning to the end quarter.