Reuters columnist Rolfe Winkler points us to a recent speech and presentation by Fed governor James Bullard.
The speech, Winkler says, is a direct refutation of economist Paul Krugman’s ideas that inflation, potentially triggered by extremely low interest rates and unconventional monetary policy, is not a threat so long as there’s a large amount of `slack’ in the US economy. Slack occurs when the output gap is a negative number — when the economy is below its full potential — and in traditional economic theory implies deflationary risks as companies cut prices and jobs to deal with the spare capacity.
But Bullard, for one, is having none of this slack nonsense.
Here’s what he said, as summarised by the St. Louis Fed:
Bullard also cautioned that policymakers should not place too much emphasis on output gap estimates when trying to assess inflation risks in the medium-term.
“I am concerned about a popular narrative in use today—the narrative being that the output gap must be large since the recession is so severe,” he said. “And so, any medium-term inflation threat is negligible, even in the face of extraordinarily accommodative monetary policy. I think this narrative overplays the output gap story.”
He added that measuring the gap is very difficult, both theoretically and practically. He cited research that shows much of the inflationary run-up in the 1970s can be attributed to a misreading of the output gap at the time. “Even if economists were to accept a particular measure, the empirical relationship with inflation is not robust,” he said. In addition, traditional output gap measures do not account for the concept of bubbles.
“It has been popular to describe recent events as a collapse of a bubble in housing. A look at the housing data makes a convincing case,” Bullard said. “But when it comes to calculating traditional output gaps, there is no notion of a bubble. If part or most of the fall in output was a collapsed bubble, then today’s output gap would be smaller than it appears.” This would mean that inflation risks in the medium term are higher than otherwise thought.
Perhaps more important than the Paul Krugman angle — Bullard’s speech, we would add, is also refutation of many of the arguments put forth by Fed chairman Ben Bernanke — one of the foremost proponents of the idea that there is a huge amount of “slack” in the economy.
So, is there a gap in the Fed’s views of the output gap?
Related links:
Slackers at the Fed - FT Alphaville
A gap in the output gap - FT Alphaville
