Output gap model misleading?
Married to the Model, Or Output Gap to Get Test
Caroline Baum
April 19 (Bloomberg) -- Almost overnight, the outlook for inflation has changed.
Nothing like a little hindsight. When the Bureau of Labor Statistics reported last week that the consumer price index rose 0.5 percent in March and 0.4 percent excluding food and energy, a chorus of ``I told you so's'' drowned out protests that it was ``just a one-time event.''
No one thinks core inflation is running at the 4.4 percent annualized rate implied by the March CPI. But even the folks at Goldman, Sachs & Co. were forced to raise their forecast for core inflation from 1.2 percent for this year and next based on the news.
The March CPI had its share of one-time events. Apparel prices, which make up 4 percent of the CPI, posted one of their rare increases in the last six years. And lodging away from home, a volatile category that accounts for 3 percent of the CPI, rose an outsized 3.8 percent.
But what about the index's long-standing depressants that are starting to reverse? Used car prices, which plummeted almost 12 percent in the last year in the CPI, are now rising briskly, according to actual transaction prices recorded by Manheim, the largest and highest volume wholesale automobile auction company in the world.
Turn in Cycle
Zero percent financing induced a surge in auto sales in the fourth quarter of 2001. Those vehicles ``started to hit the used- car market in the summer and fall of 2003 when they were two years old, depressing prices,'' said Ian Shepherdson, chief U.S. economist at High-Frequency Economics in Valhalla, New York.
Apart from the individual components, the CPI suggested that the long decline in goods prices is over. The prices of non-food, non-energy commodities rose for the second consecutive month in March; prices were unchanged in January following 16 consecutive monthly declines. The pattern suggests the weaker dollar is beginning to lift tradable goods prices.
The apparent turn in the inflation cycle has brought protests from economists who rely on the output-gap model to determine which way the inflation winds are blowing.
The output gap is the difference between what the economy can produce (potential GDP) and what it is producing (actual GDP). It requires assumptions about potential output, which requires assumptions about the growth in the labor force (not hard) and in productivity (very hard).
Theory vs Reality
Theoretically, when the output gap is large -- when there is plenty of slack in resources, such as labor and capital -- inflation should fall. The reverse is true when the gap is closed, when actual output is growing faster than potential.
Academic economists may disagree on whether it's the level of the output gap or the change that matters. They don't challenge the theoretical basis, which is odd since there are so many real-world examples that do. The 1970s witnessed lots of slack and lots of inflation. The late 1990s witnessed no slack and low inflation.
That's why signals from financial markets -- the slope of the yield curve, the foreign-exchange value of the dollar and sensitive materials prices -- are considered in some quarters to be timely leading indicators of economic growth and inflation.
Denial
While these and other asset prices ``provide timely information, particularly about market expectations, that is difficult to obtain elsewhere... extracting accurate information from asset prices and yields is more difficult and requires greater sophistication than is commonly supposed,'' Federal Reserve Governor Ben Bernanke said in a speech Thursday to the Investment Analysts Society of Chicago.
Bernanke went through a checklist of various asset prices, which, while providing ``useful feedback'' to policy makers, are ultimately too noisy or volatile to give a reliable signal.
The TIPS spread, or the difference between inflation-indexed and nominal bonds, ``overstates the market's expected rate of inflation,'' Bernanke said. The yield curve is ``hardly a foolproof forecasting tool. And interest-rate futures contracts, while ``good estimates of market expectations of policy at short horizons of six months,'' are ``misleading'' for longer-term horizons.
Bernanke's World
In Bernanke's world, market signals take a back seat to the output gap. With the unemployment rate at 5.7 percent and industry operating at 76.5 percent of capacity, ``there is still an output gap that will continue to create some downward pressure on inflation,'' Bernanke said.
As recently as March 16, the Fed thought the risk of inflation falling was greater than the risk of it rising. Many economists think the Fed will drop the biased risk assessment at its next meeting on May 4.
``Why look at the output gap when all measures of prices are going up?'' said Joe Carson, director of global economic research at Alliance Capital Management. ``Export prices, import prices, producer prices and consumer prices are all rising.''
There's always a chance the current acceleration in inflation from very low levels could be a blip, or an inflation scare. Like financial asset bubbles, blips are unknowable until after the fact.
What makes Carson think the acceleration in inflation isn't temporary -- the core CPI rose 2.9 percent on a quarterly annualized basis -- is the nature of the inflation process itself.
``What you want to know is, how high and for how long is inflation going to rise,'' Carson said.
Inflation Process
The inflation process has three drivers, according to Carson. ``At root, inflation is a monetary phenomenon,'' he said. ``In the past 20 years, inflation fell following the ratcheting down of real money and (bank) credit growth. Now it's turned up.''
The second driver is inflation expectations, which have been rising at the household level. The University of Michigan Survey of Consumers reported that average inflation expectations one year out rose to 3.6 percent in early April.
Now businesses are joining the fray. The percentage of manufacturers who expect to receive higher prices six months out has been trending higher for almost a year, according to a monthly Philadelphia Fed Survey.
The third element in Carson's inflation recipe is a policy mistake. The Fed ``can kill or start the inflation process,'' he said. If inflation begins to take hold and the Fed doesn't believe it can be sustained, which is the prevailing view right now, policy makers can compound the damage.
``They've achieved price stability,'' Carson said. ``Inflation actually fell below their comfort zone. So they are unlikely to raise rates in a dramatic fashion.''
In 1994, the financial tinder, or money, to ignite inflation was missing. That's not the case today. Inflation expectations are on the rise as well.
Given the combustible mix, the Fed can't afford to play with matches.
quote.bloomberg.com |
