Talk of the inevitable incoming inflationary spike has increased as gold broke through $1000 an ounce, Chairman Bernanke discussed the Fed retracting liquidity and money supply surged. Of course this chatter has spilled into the bond market and is one of the legs of the “short the bond bubble” theme. However, a close inspection of the mechanics of inflation suggest that it may be a long time before we have to worry about rising prices.
Inflationary pressures are generally attributed to too much money chasing too few goods. The monetarists have focused on the recent massive spike in money supply, specifically monetary base. The argument goes that eventually that money will find its way into the hands of consumers who will begin to purchase goods. These purchases will prompt factories to ramp up production. In the process of increasing production the factories will demand more raw materials which will lead to supply shortages. More demand chasing the stagnant supply will lead to inflation. The following hockey stick chart has the Chicago crowd sweating in their Bears jerseys.
click to enlarge
The narrow view of simply observing money supply assumes that producing more goods requires more resources, but that is not always the case. We must also take into account the stage of the business cycle and the ability of the economy to produce more goods with current resources. One tool for measuring this is capacity utilization, which attempts to determine the percentage of “normally” operating US factories. Currently capacity utilization is running at roughly 74%; the highest level of capacity utilization in the last 36 years was 88.65% in October 1973. The implication is that the economy has plenty of slack in the system and could produce more given current resources.
Another way of measuring the production potential of the economy is the output gap. The output gap is the difference between the estimate of what the economy could produce and what the economy is actually producing. The “gap” between potential and actual output is a measure of tightness or slack in the economy. The Congressional Budget Office (CBO) produces a reliable estimate of the full potential of the economy. If the economy is producing at or above the estimated levels then businesses must increase consumption of resources, i.e. raw materials and labor. If the economy is producing below potential, then companies do not have to chase after supplies or add workers.
The US economy is currently in a period of significant slack, therefore even if the Federal Reserve’s liquidity injections do create demand, there is plenty of slack in the economy to soften the inflationary implications.
The chart above illustrates both the output gap and the change in CPI since 1967. The output gap is calculated by subtracting the CBO estimate of GDP potential from actual GDP.
Currently, the US economy is producing well below potential output, resulting in the highest output gap since 1967. The chart also incorporates CPI as a measure of inflation. Looking further into the relationship we find that output gaps lead to disinflation and when the economy is producing more than potential estimates, inflation follows.
The table above tracks all the output gaps, showing inflation peaks and troughs from 1967 to present. Since 1967, inflation has only occurred after an output gap trough, i.e. when the economy was producing more than estimated potential. In those cases, inflation peaked between 6 and 22 months later. The exact opposite occurred when the economy was producing less than potential. Since 1967, there have been five output gap peaks, and in all five instances disinflation resulted. Moreover, this disinflation continued for 9 to 29 months.
Currently, the US economy is operating with a record output gap. If by some miracle the economy recovers tomorrow, then we could expect at least nine months of disinflation and then another 6 months before a spike in inflation.
Since this appears to be the worst economic crisis since the depression, it is reasonable to use the extreme estimates. That would mean 29 months before an end to disinflation and another 22 months before a peak in inflation. For the calendar-challenged, that is over four years before any serious inflationary risk.
Of course there are many other reasons to short bonds (including an increasing supply), but those who are betting on inflation better get a good book, because it is going to be a long wait.
Disclosure: I am long Treasury Bonds.