Here’s further evidence that the Fed is somewhat split on the output gap theory and the amount of ‘slack’ in the US economy — and by extension, the inflation and deflation risks that face it.
Slack occurs when the output gap is a negative number — when the economy is below its full potential. In traditional economic theory, that implies deflationary risks as companies cut prices and jobs to deal with the spare capacity. A high deflation risk would imply continued low interest rates — and perhaps liquidity ops — from the US central bank.
In fact, Fed chairman Ben Bernanke has been a prime proponent of the output gap theory — saying that the amount of slack in the US economy means the risk of deflation is far higher than the risk of the inflation. Recently, however, we’ve seen a Fed governor, James Bullard, challenge this view, saying that the method of calculating traditional output gaps doesn’t take into account the idea that output may have been artificially boosted by recent (bubblicious) activity.
On Tuesday Fed vice chairman Donald Kohn took aim at the output-gap detractors:
… I expect that inflation will likely be subdued, and that, for a while, the risk of further declines in underlying rates of inflation will be greater than the risk of increases. That outlook rests importantly on two judgments: First, that the economy will be producing well below its potential for some time, which will directly restrain production costs and profit margins; and second, that inflation expectations are more likely to fall than rise over time as the level of real activity remains persistently less than its potential and actual inflation remains low.
We can never directly observe the level of economic potential–it is largely inferred from the behavior of related variables, like output, productivity, costs and prices. In that regard, a widely discussed upside inflation risk is the possibility that as a result of the financial turmoil and deep recession, the extent of economic slack in the economy is not as great as is commonly estimated. One possibility is that the steep drop in investment has caused a decline in capital services that could damp the rise in productivity. Another possibility is that the needed reallocation of resources away from a number of sectors–including finance, construction, and motor vehicles–will have a restraining influence on potential output for a time. In addition, prolonged periods of unemployment could have adverse effects on the skills of workers and their attachment to the labor force.
The financial crisis may also have affected potential output by reducing the ability of financial markets to effectively lubricate the flow of credit throughout the economy–and to allocate capital resources to their most productive uses. The deterioration in the health of the financial system conceivably may have disrupted the credit allocation system enough to seriously impair the efficiency of business operations, and this impaired efficiency could show up at some point in more meager gains in productivity. And, some have argued, as governments seek to build more stable financial and economic systems, they may impede innovation and efficiency.
Each of these arguments contains a grain of truth, and they are worthy of further research. But in my view, the cumulative reduction in aggregate demand has been much greater than any possible cutback in potential supply. The unemployment rate has risen by 5 percentage points in a very short period, and capacity utilization in industry hovers just above its lowest level in the history of the series, dating back to 1948. The downward pressures on both prices and labor compensation reinforce my impression that our economy is operating well below its productive potential. And, if anything, productivity has been surprisingly strong, not weak, in recent quarters.
So Kohn is firmly in the `slack’ camp and on the deflationary side of the equation.
What’s of interest now, however, is how the internal politics of the Fed play out.
The FT’s Money Supply blog notes:
Kohn is probably a shade to the dovish side of Bernanke at this point, but he is a heavyweight and his arguments may carry more weight than those of a number of hawkish regional presidents.
Related links:
Slackers at the Fed – FT Alphaville
A gap in the output gap – FT Alphaville