Looks like the inflationistas may have to continue laying low, at least for a while. A chart from the release of this morning’s CPI numbers:
As you can see, the year-on-year change in the core index has remained at a measly 0.9 per cent for the last four months, while the headline number had been coming down until flattening this month. No surprises, really, as the spread between 5-year Tips and Treasuries has been anticipating this decline since the end of April.
But you didn’t have to be looking at recent Tips spreads to have known that disinflation pressures have been taking hold.
According to a recent paper by the IMF’s André Meier (with a hat tip to Menzie Chinn for the link), it’s likely that these pressures have been building at the same as the output gap, roughly defined as the difference between potential and actual economic output, has persisted.
From the abstract, emphasis ours:
This paper studies inflation dynamics during 25 historical episodes in advanced economies where output remained well below potential for an extended period. We find that such episodes generally brought about significant disinflation, underpinned by weak labor markets, slowing wage growth, and, in many cases, falling oil prices. Indeed, inflation declined by about the same fraction of the initial inflation rate across episodes. That said, disinflation has tended to taper off at very low positive inflation rates, arguably reflecting downward nominal rigidities and well-anchored inflation expectations. Temporary inflation increases during episodes were, in turn, systematically related to currency depreciation or higher oil prices. Overall, the historical patterns suggest little upside inflation risk in advanced economies facing the prospect of persistent large output gaps.
And the paper includes this graph to illustrate the relationship between persistent large output gaps (PLOGs) and inflation:
There are different ways of measuring the output gap, but the Congressional Budget Office explains it as the difference between actual GDP and “the output that could be produced if all labor and capital were fully employed”. And its most recent estimate, from early in the year, found a gap of 6.5 per cent of GDP.
Michael Kiley of the Fed graphed the CBO’s estimates going back nearly 25 years (another hat tip to Menzie Chinn), and it’s clear that the gap most recently turned negative at the end of 2007:
As for what this means right now, later in the paper by the IMF’s Meier we come across the following passage:
For the current inflation outlook in most advanced economies, these findings would suggest little upside inflation risk, although further disinflation may also be limited in general.
He also adds that there is “little prima facie evidence in our sample to support ‘speed limits’ (in the sense of higher inflation when a negative output gap is closing fast) or a close link between inflation dynamics and developments in broad money.”
Ever the careful scholar, Meier cautions that measures of the output gap are imperfect, and that historical relationships won’t necessarily hold this time round.
But if they do hold, then his conclusions are somewhat comforting. They suggest that there isn’t much prospect for an unwelcome inflationary spike spurred by looser monetary policy; but they also mean that outright deflation is also unlikely. And policymakers can get on with the task of closing that pesky output gap and reducing unemployment.
Which is another challenge altogether.
Related links:
Still Minding the Gap – Inflation Dynamics during Episodes of Persistent Large Output Gaps – IMF
Persistent Large Output Gaps, Disinflation and Deflation – Econbrowser
Mind the Gap – Econbrowser
Inflationistas, deflationistas and Goldilockeans – FT Alphaville