Output gap theory is squishy concept for Fed to lean on
April 20, 2009
By Caroline Baum
It always ends up at the same place. Any discussion of inflation - what it is, what causes it - comes back to that never-ending debate between money and the output gap.
First, some background. Late Nobel laureate Milton Friedman is remembered for many things, among them his oft- quoted observation that inflation is "always and everywhere a monetary phenomenon". If the central bank creates more money than the public wants to hold, the public will spend it, bidding up the prices of goods and services.
It's easy to lose sight of Friedman's axiom nowadays. Central bankers often talk about higher oil prices and rising wages as if these increases cause inflation rather than reflect it.
The other theory of inflation, popular among Keynesian economists and Phillips Curve advocates, is something called the output gap, or the difference between the economy's actual and potential output.
The economy's potential growth rate is circumscribed by the growth in the labour force and productivity. There are estimates that have turned out to be overly optimistic (in the 1970s) or too pessimistic (in the 1990s). In both, the perceived "gap" failed to predict inflation, or its direction, correctly.
Actual output, or real gross domestic product (GDP), is also an estimate. When actual GDP consistently exceeds potential GDP - the gap is gone - inflation accelerates, according to the theory. On the other hand, when potential is greater than actual - when, for example, the unemployment rate is high and industries are operating below capacity - the gap provides a buffer.
There is something superficially appealing about the output gap model. After all, if the demand for goods and services exceeds the economy's ability to produce them, businesses raise prices to allocate scarce resources. So what's the matter with that logic?
For starters, aggregate measures - aggregate demand, aggregate supply - and inflation are macroeconomic concepts. Prices are set at the firm, or micro level. High unemployment among auto workers has nothing to do with the price of beans, even though expectations about aggregate prices are a consideration for businesses, according to Marvin Goodfriend, a professor of economics at Carnegie Mellon's Tepper School of Business in Pittsburgh.
There's a bigger problem. The theory is "unsupported by statistics and history", says Paul Kasriel, the chief economist at Northern Trust in Chicago. Kasriel tested the correlation between the output gap and the core personal consumption price index and found that the gap and inflation are negatively correlated.
Estimating the output gap is a vital ingredient in many official forecasts.
For example, in its March budget and economic outlook, the Congressional Budget Office said real GDP would average 7 percent below potential for the next two years and that it did not expect the output gap to close fully until about 2014.
That means the gap gives the Federal Reserve breathing room to address the financial crisis without worrying about inflation. Or else it's a squishy construct to hang your hat on if you're Fed chairman Ben Bernanke looking at a $2 trillion (R18 trillion) federal deficit and $804 billion of excess reserves.
Caroline Baum is a Bloomberg News columnist
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