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.

Lesson 4 Potential Output, the GDP Gap, and the Intelligence Gap

This post is really about inflation but I didn’t want to mention inflation in the title so as to not scare you. Actually it is really about inflation policy so let’s start there before we get into excruciating technical definitions, mathematical equations, and kimchi recipes.

Some of you are old enough to remember inflation. Inflation means the cost of cherished goods and services is rising. One day you went to Whole Foods for one small bag of groceries and it cost you $1,000. Today you go and that same bag of non-pesticidal fruits and nuts costs you $1,100. You would say, yikes Helen, those dirty scum-#$%^&*s at Whole Foods are ripping us off and making it impossible to send our genius Golden Retriever Bogey to Harvard. Or you might simply say that inflation was 10%.

Since the great recession in 2008 the inflation rate has been very low in the USA. While the inflation rate was generally rising between 2001 and 2008 it has been falling ever since. It did rise briefly to nearly 4% during 2011, but it reversed course and inflation has been falling ever since.

So there are great minds who basically say “Inflation who?” implying that inflation is like your brother-in-law after the divorce. You ain’t gonna have to see him again! Very smart economists who teach at wonderful places like San Diego State and Harvard would swear on a stack of Paul Krugman articles that the Fed can pump in money and the government can spend its way to oblivion and back – and still not awaken a comatose inflation dragon. I know. I am mixing metaphors. Or was that a simile?

I know you have been waiting patiently for some really boring definitions but I had to get you ready. If you are like a lot of my friends, you haven’t read an economics book since Prof Schaffer’s class in 1964. Potential Output and the GDP Gap exist for one and only one reason – to help us predict future inflation. The above suggests that inflation is hiding at the moment. But this blog is all about how and why inflation might awaken from its long slumber and possibly be in a very ugly mood.

Remember GDP? GDP is a nation’s output. It is measured fact. It is the size of that pile of goods and services that got produced this year. It could be really big this year because Zeus was happy or it might be small because Kim Kardashian forgot to go shopping. Either way, GDP is what got produced.

Potential GDP is part of a fairy tale or what economists like to proudly call a counterfactual. Potential GDP is what GDP could have been. It’s like your kid’s potential. Okay, so he can’t actually hit the broadside of a barn with a large pumpkin but you are pretty sure that if he practices a lot he will soon be starting on the mound for the Royals. Potential GDP is how much output would have been produced this year if the economy’s resources were fully utilized. It is possible that actual GDP could equal its potential in a given year – but honestly, when is the last time your kid started for the Royals?

The GDP Gap is the difference between Actual GDP and  Potential GDP. Most of the time, the current GDP is well below its potential because most of the time resources are not being fully utilized. Thus, most of the time the GDP GAP is negative.

The main productive resource that tends to lag is employment. Those dern workers just love to sit around and watch Oprah every day instead of going to work and producing huge mounds of widgets and zidgets. Or those dad-gummed firms love to fire workers who then sit around and watch Oprah. In either case, if there are unemployed workers looking for work, this excess shows up as a negative GDP gap.

Here is the point – an excess of workers seeking employment (or improved employment) and a corresponding negative GDP Gap represent a weak economy with weak spending It is one that grows slowly and one that is not capable of producing inflation. As a result the US Fed is more concerned about the weak economy than it is about rising inflation. That relative concern retards their movement to a more normal policy. It puts off the day when the Fed removes a lot of money and stimulus from the economy. When employment improves and the GDP GAP turns toward positive territory, then the Fed will turn its sights towards mediating inflation. The big question now is when will that day come? When will policy return to normal? The GDP Gap is heading towards positive so we know a policy change will come.

The intelligence gap has to do with the Fed’s reluctance to move to a saner policy. Why do I say saner? The economy is exhibiting a return to stronger economic growth. Inflation is not one of those things that require bugles and a formal announcement heralding its arrival.  I know that GDP turned sour in the first quarter of 2015 but everyone including your barber’s Doberman knows about the temporary factors like a massive dock strike and storms attributed to global warming caused economic problems in Q1 that will not be repeated in Q2.

Now we have economists giving the Fed even more ammunition to continue a risky policy. A recent report (Changing Labor Force Composition and the Natural Rate of Unemployment, by Daniel Asronson, Chicago Fed Letter, #338) explains that labor will not be fully employed until the unemployment rate reaches between 4.5% and 4.9%. That means we will have a negative GDP Gap until the unemployment rate reaches about 4.5%. That means the Fed has a numerical excuse to not worry about inflation and to not engage in a more conservative policy for quite a while.  Meanwhile the economy gains momentum and some measures of inflation (percentage change in the CPI less food and energy) are closing in on the 2% goal value. Once at the goal value notice that it won’t take long to exceed it. And then the Fed will be in a really difficult position. Do they really want to have to aim all their guns on inflation knowing that a major abrupt change in policy will greatly weaken spending in the economy.

A quicker return to a gradual approach that started yesterday is what was needed. Waiting until tomorrow promises going from the frying pan to the fire.