Bernanke’s Exit Plan May Fall Through the Gap: Caroline Baum
Commentary by Caroline Baum
April 12 (Bloomberg) -- What is it that no one can see, hear, smell, taste or touch, yet everyone knows is there?
Answer: the output gap.
In common parlance, the output gap is the difference between what the economy can produce and what it is producing at any given time. The fact that we can’t measure the first with any degree of accuracy and are still revising the second 30 years after the fact has never shaken the faith of those relying on the output gap to gauge future inflation.
Nor did the experience of the 1970s, a period of high unemployment (lots of unutilized labor) and high inflation, sour economists on their chosen yardstick.
Instead of inspiring caution about a theory that relies on the debunked Phillips Curve -- a representation of the presumed trade-off between inflation and unemployment -- the ‘70s experience was filed away under “measurement error.” The seismic shift (down) in trend productivity growth lowered potential growth, and an easy monetary policy goosed demand for goods and services beyond the economy’s ability to supply them.
That Federal Reserve policy makers continue to rely on a theory that is only as good as our ability to measure beasts known as “aggregate supply” and “aggregate demand” is a cause for concern, even at a time when real gross domestic product is 6.5 percent below the economy’s potential GDP, according to a January estimate by the Congressional Budget Office.
Slacking Off
The Fed is in no hurry to normalize short-term interest rates precisely for that reason. The “likely continuation of substantial resource slack” augurs for subdued inflation for some time, according to the minutes of the March 16 meeting released last week.
Resource slack refers to excess capacity in both labor and capital. The unemployment rate has been stuck at 9.7 percent for the last three months, down from the cycle high of 10.1 percent in October. The capacity utilization rate -- another squishy concept -- at the nation’s factories, mines and utilities stood at 72.7 percent in February, well below its long-run average.
Even if the CBO is correct and the output gap doesn’t close until 2014, there are risks to leaving the funds rate at zero for what the Fed says is “an extended period.” Adjusted for inflation or inflation expectations, the real funds rate is negative. In other words, banks are being paid to borrow from the Fed and arbitrage the steep yield curve or make loans to businesses and households.
Shaky Foundation
So far they’ve only taken the bait on Treasuries. Bank loans and leases continue to contract, as they have for the past year and a half. For the moment, the $1 trillion banks are holding in excess reserves are staying put. The Fed’s challenge is to prevent those reserves from fanning inflation as it nurtures the economy back to health.
In addition to operational problems with the output gap, there are theoretical issues as well, according to Stephen Stanley, chief economist at Pierpont Securities LLC, a registered broker-dealer for government securities in Stamford, Connecticut.
“I don’t think in theory that’s the way prices are set,” he says. “It’s not the level of activity but the change in activity” that matters.
Fed officials made, and relied on, the same argument about excess slack in 2003, making one final cut in the funds rate to 1 percent to insure against deflation.
By all rights, inflation should have fallen in 2004. Instead, it rose. Pick any inflation measure, with or without food and energy, and you can see the consistent rise in prices through 2004 into 2005. And inflation in goods and services prices turned out to be the least of our worries.
Guarding Against Repeat
To be sure, policy makers are aware of the risks; “they just view them as asymmetric,” Stanley says. “And they’re in a state of denial about the role of monetary policy in creating these bubbles.”
Never fear. Our trusted regulators “noted the importance of continued close monitoring of financial markets and institutions -- including asset prices, levels of leverage, and underwriting standards -- to help identify significant financial imbalances at an early stage,” according to the minutes.
All clear for the moment, with no signs of “emerging misalignments in financial markets or widespread instances of excessive risk-taking.”
Phew. And here I thought we might relive the last crisis.
Even now, with that yawning output gap, the Fed’s preferred inflation measure, the core personal consumption expenditures price index, isn’t falling. The index has shown three monthly declines in the past decade, two of which occurred during the current crisis.
It will take foresight, determination and guts for Fed chief Ben Bernanke to normalize interest rates, keep the economy on an even keel and prevent an outbreak of inflation. That task is a lot harder than simply minding the gap.
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