Global economy – cut the slack
This post is a guest contribution by Joachim Fels of Morgan Stanley.
How much slack? Almost two years after the end of the Great Recession, it remains unclear what the financial crisis has done to the level and the growth rate of potential GDP in the advanced economies. ‘Potential’ is the maximum level of output that could be produced without putting so much pressure on resources that it creates inflation. Uncertainty about potential output translates one-for-one into uncertainty about the output gap – the difference between (observed) actual GDP and (unobserved) potential GDP – which measures the amount of spare capacity, or ‘slack’, in the economy. And, with inflation generally thought to be related to the amount of ‘slack’ in the economy, uncertainty about the output gap translates into uncertainty about the inflation outlook.
Standard measures suggest…still a lot: Most standard measures suggest a fairly large current output gap in the major advanced economies. For example, the OECD predicts that the output gap in the euro area and in the US, while expected to narrow this year, will remain in excess of 3%, implying that the level of actual output will be more than 3% below potential. With this much spare capacity left in the economy, it might seem reasonable to assume that domestic (as opposed to imported) inflation pressures will remain fairly subdued.
However, estimates of the output gap are highly uncertain and prone to revision: The OECD’s own estimates of the output gap have been changing over time. Each December, the OECD re-estimates past, present and (two years into the) future output gaps based on the available data at the time of the estimate. For example, with hindsight, it appears that in the 2004-07 period, there was much less spare capacity in both the US and the euro area economies than the OECD assumed during those years, probably reflecting overly optimistic initial assumptions about potential output growth. To the extent that central banks, which use similar approaches to gauge the output gap, relied on these real-time estimates, they underestimated the underlying inflation pressures and kept interest rates too low for too long, and thus likely contributed to the inflation overshoots before the financial crisis.
Not a garden-variety recession: Due to the nature of the financial crisis and the Great Recession, estimates of potential GDP and the output gap are even more uncertain than usual. In particular, the crisis may have severely damaged the level (and the growth rate) of potential output by making part of the capital stock in the advanced economies economically obsolete. To see why, consider that the economic expansion of 2002-07 was fuelled by a credit boom – credit was cheap and widely available. The sectors that benefited most from this boom were the financial sector (which helped to fuel the bubble), construction and real estate (which were artificially boosted by low interest rates and easy availability of credit) and consumer-related industries (as consumers thrived on easy credit and higher (perceived) housing wealth).
Capital and skills damaged: Yet, the post-bubble world looks very different: credit is no longer easily available, the financial sector is much more heavily regulated, housing markets are still weak and consumers remain in deleveraging mode. As a consequence, part of the capital stock in the credit-intensive sectors must have become economically obsolete. This not only applies to physical, but also to human capital. Workers who acquired special skills in sectors that benefitted from the credit bubble find their earnings capacity reduced in the post-bubble world and may not have the skills needed in other sectors that are now expanding.
Remember the Seventies? In fact, this shock to potential output is conceptually similar to the shock of the mid-1970s. Back then, the surge in oil prices destroyed a large chunk of potential output in the energy-intensive manufacturing sector. While the factories and shipyards were still around, many of them were no longer economically viable at higher energy prices. This time round, the credit crisis reduced potential output not in the energy-intensive but in the credit-intensive part of the economy. Back in the 1970s, the traditional models were slow to pick up the shock to potential output and thus massively overestimated the size of the output gap. As documented amply by the work of Athanasios Orphanides (now a member of the ECB Governing Council), real-time estimates in the mid-1970s overestimated the size of the US output gap by as much as 10 (!) percentage points, thus suggesting vastly more room for non-inflationary growth than actually existed. This (with the benefit of hindsight) overly optimistic view of the output gap contributed to overly expansionary monetary policies and helped to produce the Great Inflation of the mid-to-late 1970s.
Wide variance in gap estimates: Given the experience of the 1970s, central banks are naturally keen not to repeat the same mistakes, which may help to explain why the ECB has started to raise interest rates even though standard measures of the output gap still show ample slack. By contrast, the Fed seems to be placing more confidence in measures that show ample slack both in the overall US economy and also the labour market. Yet, different approaches to estimating potential output and the ‘natural’ (non-inflationary) rate of unemployment yield widely diverging results for the US. We compare the Congressional Budget Office’s output gap estimate to another estimate that we derive from a small model of the US economy which we have been using to estimate the natural (or neutral) rate of interest. While the CBO estimate, which is widely used, shows actual output some 5% below potential, our own model-based estimate suggests a much smaller output gap and thus much less slack in the economy. Note that we do not claim that our estimate is the correct one and that the CBO estimate is wrong. We merely note that different approaches to estimate the output gap can yield widely divergent results.
This point is illustrated further by a comparison of seven alternative estimates of the US output gap and the implied natural rates of unemployment conducted by Justin Weidner and John C. Williams at the San Francisco Fed (John Williams recently became President of the San Francisco Fed and is thus now a member of the FOMC). In an update of a 2009 paper, their alternative estimates of the US output gap in 4Q10 range from -7.5% to -1.8%, and their derived estimates of the natural rate of unemployment range from 5.2% to 8.6% (with the latter being not far below the actual rate of unemployment.
Further significant inflation upside possible: Clearly, it is impossible to say without the benefit of hindsight which measure is the most accurate. Yet, given the experience of the 1970s and the nature of the financial crisis, we think there is a distinct possibility that there is much less slack in the advanced economies than is generally presumed. Together with a super-expansionary global monetary policy stance and EM-led global inflation pressures, this adds to our worries about potentially significant upside to inflation in the advanced economies over the medium term.
Source: Joachim Fels, Morgan Stanley, May 20, 2011.
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