The Output Gap Trap For Policymakers

Includes: GLD
by: Disruptive Investor

The output gap, which tells if the level of gross domestic product (GDP) is running significantly under the potential GDP, is an important indicator for policymakers in deciding the appropriate time for policy firming.

The importance of the output gap for policymakers is underscored from the most recent speech by Mr. Ben Bernanke - Monetary Policy since the Onset of the Crisis (Jackson Hole, Wyoming).

Mr. Bernanke states that -

The views of Committee members regarding the likely timing of policy firming represent a balance of many factors, but the current forward guidance is broadly consistent with prescriptions coming from a range of standard benchmarks, including simple policy rules and optimal control methods. Some of the policy rules informing the forward guidance relate policy interest rates to familiar determinants, such as inflation and the output gap. {Emphasis Added}

But a number of considerations also argue for planning to keep rates low for a longer time than implied by policy rules developed during more normal periods. These considerations include the need to take out insurance against the realization of downside risks, which are particularly difficult to manage when rates are close to their effective lower bound; the possibility that, because of various unusual headwinds slowing the recovery, the economy needs more policy support than usual at this stage of the cycle; and the need to compensate for limits to policy accommodation resulting from the lower bound on rates.

The theory of the output gap and its impact on inflation was also discussed in the most recent FOMC meet.

Meeting participants again exchanged views on the extent of slack in labor and product markets. A number of participants expressed the view that structural changes in the labor market were not sufficient to explain the high level of unemployment. Those participants saw substantial slack in resource utilization and hence continued to judge that inflation was likely to remain subdued over the medium term as the economy continued to recover. However, several other participants interpreted the moderate pace of the recovery as pointing to a more substantial markdown in the trajectory of potential output.

The staff's forecast for inflation was little changed from the projection prepared for the June FOMC meeting. With crude oil prices expected to decline a bit from their current levels, the boost to retail food prices from the current drought in the Midwest anticipated to be only temporary and relatively small, longer-run inflation expectations remaining stable, and substantial resource slack persisting over the forecast period, the staff continued to project that inflation would be subdued through 2014.

Very clearly, output gap estimates are being used as an indicator of sluggish economic activity going forward. This, in turn, serves as a rationale for keeping interest rates artificially low for a prolonged period.

This article looks into the expected output gap for the United States and discusses the probable reasons for high inflation along with a high output gap.

The chart below gives the output gap for the United States from 1980 to 2016E. The 2012-16 estimates are from the IMF.

As per current estimates, output gap in the United States is expected to remain negative until 2016. If we go with the mindset of policymakers, interest rates might remain artificially low until 2016.

I am of the opinion that the U.S. will witness significantly higher inflation if interest rates remain low for the next 3-5 years. This is irrespective of the high output gap during these years. I am not talking about the reported inflation, but the actual inflation for a typical U.S. household.

Zimbabwe is one example of a country that witnessed a high output gap and high inflation. Even the U.K. has a relatively high inflation when compared to the output gap.

I am certainly not suggesting that the U.S. will have a Zimbabwe-style inflation. I am just indicating that inflation is entirely possible with high output gap. I foresee double digit inflation for U.S. households over the next 3-5 years if policy firming is avoided with output gap as an excuse.

So far, my discussion has been pertaining to the mindset of policymakers and my personal expectations on inflation. I will now focus my discussion on the reasons for believing that high inflation is a probability in the U.S. along with high output gap.

I had discussed high deficits for the U.S. in the next 4-5 years in my previous article. On a conservative basis, one can expect deficits of USD4-5 trillion over the next 5 years. Higher deficits would lead to a weaker dollar, which is a symptom of inflation.

A weaker dollar would be bullish for global commodity and energy prices. This will result in higher outlays for energy and food.

At the same time, a weaker dollar would lead to higher import prices. With significant consumer goods being imported, prices will trend higher with growing debt and deficits.

Therefore, a weaker dollar can ensure that consumer inflation (including food and energy) remains high even when the output gap is significant.

It is also important to understand that when economic activity is weak and consumers are leveraged, the private sector will scale down its capacity utilization to ensure optimal profits. In such a scenario, the output gap remains high. It does not necessarily indicate deflation.

Also, artificially low interest rates do not contribute towards economic growth or in reducing the output gap with consumers being more cautious in a high unemployment scenario. In other words, the nature of the problem with the economy needs to be identified before concluding that a high output gap will lead to deflation. Related to the nature of the problem faced by an economy is the diminishing impact of debt on economic growth for the United States.

The diminishing impact of debt is an important reason to believe that high inflation can happen in times of high output gap.

From 1960 to 1980, the total credit market debt increased by USD3.9 trillion. In the same period, the GDP increased by USD2.4 trillion. In other words, one dollar of debt had an incremental impact of 61 cents on the GDP.

From the year 1980 to 2000, the total credit market debt increased by USD20.7 trillion. The GDP in these 20 years increased by USD9 trillion. Therefore, one dollar of debt had an incremental impact of 44 cents on the GDP.

Coming to the most recent decade, the total credit market debt from 2000 to 2011 increased by USD27 trillion while the GDP increased by USD5.2 trillion. The impact of debt on GDP growth during this period has witnessed a sharp decline. For every one dollar of debt, the incremental impact on GDP was just 19 cents.

Clearly, additional debt having minimal impact on GDP growth with most of the debt manifesting itself in the form of asset price increases and general consumer price inflation.

One can argue that quantitative easing has not resulted in significant inflation in the last 3-4 years. Going by past evidences, there is a lag between excessive monetary easing and inflation. Therefore, I would not be surprised if inflation gradually trends up to uncomfortable levels.

The factors discussed above convince me that stagflation is a possibility and artificially low interest rates (negative when adjusted for inflation) can do more harm than good for the economy.

From an investment perspective, I will remain bullish on gold for long term and I expect the best phase of the bull market for gold in the next decade. Accordingly, I will consider investment in physical gold or gold ETF. The SPDR Gold Shares (NYSEARCA:GLD) ETF would be a good option for considering exposure through ETF's.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.