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The Great 'output Gap' Masks The Real Threat Of Inflation

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The great 'output gap' masks the real threat of inflation

The so-called output gap isn’t as big as it seems. The gap – a measure of slack in the economy – may seem large after over a year of a deep recession. But some of the capacity built up during the boom is useless. That means it may not take a lot of growth before the economy hits inflationary buffers.

The consensus view is there’s currently a lot of slack in the global economy. With factories running slowly, producers won’t dare to increase prices and workers won’t push for higher wages. In fact, deflation is seen by most observers as a far greater risk than inflation.

To stave off falling prices, the authorities have cut interest rates to nearly zero and started printing money. Central bankers promise to reverse those polices just as soon as the output gap narrows sufficiently. But to get the timing right, they need a fairly precise idea of just how big output gaps are at any particular time.

The concept of a gap between what the economy is actually producing and its potential is clear enough. Think of a factory which was producing 1,000 cars a week when it was at full capacity but now is churning out only 700. Its output gap is 300 cars a week. Now gross that up over the entire economy.

So much for the theory. Measuring the gap on an economy-wide basis is fiendishly tricky.

The simplest and commonest way to get around the problem is to assume that an economy has an underlying growth rate – something like 2.8pc in the US and a bit less in Europe, where the population is growing more slowly. During a recession, the “potential†output keeps growing at this trend rate, but the actual production falls short. The longer the recession goes on, the bigger the gap.

The US Congressional Budget Office relies on this “deviation from trend†approach. The current estimate of the gap is 6.2pc. The Federal Reserve is thought to rely primarily on the CBO. The International Monetary Fund does a similar calculation and comes up with around 4pc for the US.

It’s a simple technique, but not necessarily right. Trend growth rates can only be calculated in retrospect. They are influenced by many invisible factors: most notably productivity growth and the number of workers leaving and looking for paid jobs.

What’s more, some of the output that is lost in a recession may never return. Bubbles in construction and financial services propped up growth in the US and UK. The workers displaced by the bubbles’ bursting will find it hard to get equally productive jobs soon.

Also, some of the past growth – dealing rooms that will never be filled or shopping centres that should never have been built – will have to be subtracted from the country’s capital stock.

And if a country has to change its industrial mix – as most nations will if the global economy is to be rebalanced so that, for example, Americans don’t consume so much and Chinese don’t consume so little – something will be lost in the gear shift.

Such considerations have led the UK Treasury to estimate that the country’s starting point for growth after the recession will be as much as 5pc lower than the peak level. The European Union has slipped about 3pc of growth from where it would be if the previous trend continued through the recession.

These adjustments suggest measuring the output gap by examining the deviation from the trend is problematic. Another approach is to look at how rapidly prices are changing. Since food and fuel prices don’t respond directly to the level of economic activity, they are excluded.

On this theory, if core inflation is positive – as it still is in most of the world - then the output gap can’t be huge. The inflation-analysis method suggests a modest current output gap: 2pc in the US, according to economists John Williams and Thomas Laubach.

If they are right, even a modest uptick in growth could provoke inflation. The authorities should then be encouraging everyone to get used to slower growth and higher unemployment – almost the opposite of the current policy of encouraging companies and consumers to spend more.

Put that in yoru pipe and smoke it.

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I note what you are saying and agree with you about the output gap being smaller because real productive capacity has been destroyed

I was as worried as you appear to be, but then I went through this thread headed:

My Fears About High Inflation ........, Are Starting To Fade ....... [sorry cant do the link]

Started off a sceptic about the thread, but I now agree that while inflation is a threat, it looks more of a long term rather than short term one

Interested in your views though?

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Worth a bump giving the IC story just put up on the blog.


I was reading about the Output Gap last Thursday and it is actually quite shocking. This article puts it into context, essentially firms have excess capacity, so expect deflation at least for a bit.

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Trend growth rates can only be calculated in retrospect. They are influenced by many invisible factors: most notably productivity growth and the number of workers leaving and looking for paid jobs.

More notably than those: energy availability. "Trend" growth experienced during an era of energy-plenty will not be maintained once we flip over to energy-scarcity.

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Looks like we can expect cheap Starbucks, tanning salons and BTL properties for a while yet then since these seems to have made up the UKs GDP for the last 10 years.

Unfortunately, if you need to feed yourself, warm your house or fill your car you will need to compete with 3 billion Chinese for limited resources.

Lets hope the Chinese stay poor

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So, how low do you think the CPI will go before it starts 'incredibly, against expectations' creeping up again?

I give it eight months max.

Definately by December as the VAT cut drops out then but possibly earlier as the fall in the oil price of last autumn drops out.

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