US Economy: 'Condemned to Grow'

It would happen, wouldn't it. One day after I stick my neck out far enough to say I think the equity markets are looking overpriced, and ready to take a knock, we get a string of very positive looking data, and off we go again. Well that's good, it's chastening to get humbled from time to time, but then, the game isn't over yet, not by a long stretch.

First it was the turn of the Conference Board to come in with an increase in its Index of Leading Economic Indicators, then the Department of Labour followed suit with a drop in new signings to below the dreaded 400,000 mark (386,000 provisional). Then the Philadelphia Fed waded in with its monthly industrial guage of manufacturing in the U.S. Mid-Atlantic region which leapt to 22.1 August from 8.3 in July (don't however miss the detail that the continuing higher productivity has allowed firms to do more with fewer workers, and thus delay new starts. The Philly Fed's employment index slipped sharply, to -8.7 from 0.8. ). At the same time various voices at the Fed are busy trying to reassure everyone that interest rates are set to stay low as far as the eye can see.

So where's the problem. Everything looks set to run, doesn't it. Well before we start why not look at a couple of charts. Firstly try this looks good, doesn't it? Now try this . A bit different, huh. Both the charts are of the NASDAQ composite, the first is over three months, and the second over five years. The perspective is different don't you think? What looks in the first to be a nice solid upward trend has another feel to it in the longer perspective. Sure we may be on the way up, but equally we could be about to run out of steam just one more time. Who knows? (BTW just glancing at the chart, the rebounds in the spring and autumn of 2002 seem to have had a lot more force to them than this recent one, but it's only a thought). So let's apply the same principal to industrial production. Maybe output has come back to life in the last three months, but that doesn't stop capacity utilization being still at 20 year lows. Then, and as everyone by now must surely know, there's the little problem of employment. Given the strong productivity performance and the increasing working age population the US economy may need to grow at around 4% to start generating net new employment. So where are we really? Paul Krugman puts his finger on something important in a recent NYT piece (Twilight Zone Economics):

Since November 2001 — which the National Bureau of Economic Research, in a controversial decision, has declared the end of the recession — the U.S. economy has grown at an annual rate of about 2.6 percent. That may not sound so bad, but when it comes to jobs there has been no recovery at all. Nonfarm payrolls have fallen by, on average, 50,000 per month since the "recovery" began, accounting for 1 million of the 2.7 million jobs lost since March 2001. Meanwhile, employment is chasing a moving target because the working-age population continues to grow. Just to keep up with population growth, the U.S. needs to add about 110,000 jobs per month. When it falls short of that, jobs become steadily harder to find. At this point conditions in the labor market are probably the worst they have been for almost 20 years. (The measured unemployment rate isn't all that high, but that's largely because many people have given up looking for work.) ............

Is relief in sight? Over the last few weeks two numbers have led to a spate of optimistic pronouncements. One is the preliminary estimate of second-quarter growth, which came in at a 2.4 percent annual rate — about one point higher than expected. The other is the rate of new applications for unemployment insurance, which has fallen slightly below 400,000 per week................. Just to stabilize the labor market in its present dismal state would probably take growth of at least 3.5 percent; it would take much more than that to return the economy to anything resembling full employment. Meanwhile, about those unemployment claims: somehow that 400,000-per-week benchmark has acquired a lot more significance in people's minds than it deserves. For example, claims came in at 398,000 yesterday — and this was treated as good news because it was (barely) below the magic number. Well, here's some perspective: since November 2001 new claims have averaged 414,000 per week. A number a bit lower than that might mean stable or slightly rising payroll employment — but as we've just seen, that's not nearly good enough. For comparison, in 2000 — a year of good but not great employment growth — weekly claims averaged 305,000. ............The best guess is that growth in the second half of the year will be faster than in the first half, possibly high enough to create some jobs, but not high enough to make jobs easier to find. In other words, in terms of what matters most, the economy will continue to deteriorate.
Source: New York Times
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Now this argument is interesting, since, among other things, it highlights the important difference in demographics between the US and most of the rest of the OECD. Due to record immigration across the 90's the US working age population continues to increase at a significant pace. So in fact the US has precisely the opposite problem to the other 'industrialised' economies, finding jobs for all those extra young people hitting the labour market. (Digressing a moment, I think it's time to get away from the 'many people have given up looking for work' cliche - in Japan, in the US, in Europe - I'm sure it's true, but the more I think about it, the more I think we need some better metrics. The 'official' unemployment rates are just about meaningless in terms of understanding anything - of course they're wonderful for political debate. What we need to follow is the working age population, participation rates - across cohorts - dependency ratios etc. What would be nice to know would be how the active labour force was changing as a proportion of the working age population, although even this is not too helpful until we get a better purchase on what this expression means these days, what with young people studying longer and the retirement ages about to go up. It would also be interesting to know each month how the relative participation rates across cohorts were changing, and within the 'dependent' population to have a breakdown between young and old on an ongoing basis. Bottom line: we need something like a new 'Boskin' to work out some metrics for labour market analysis, with something like a composite index as the end product, but as someone likes to say, 'oh well, never mind', at least the absence of such a thing gives us economists plenty of margin for guesswork and speculation).

All this is then compounded by the fact that the economy, when it is working is highly productive (parodying the late Rudi Dornbusch: the US manufacturing sector isn't working too regularly, but when it is, boy is it productive). So really, more than any other OECD economy the US is 'condemned to grow', and this is where we hit the snags. As I have been flagging, all that outsourcing is fine, but you need value generating activities to pay for it, you need to be able to export, and to export (as the Japanese have been finding out) you need growth somewhere else. You also need a currency which is competitively valued, but it is here that we discover just how finely balanced the whole thing is. The dollar drops, US manufacturing begins to see export opportunities, the economy starts to rev up, people see growth on the horizon, and back comes the money looking for action with the undesireable consequence that the dollar starts to climb, and the export opportunities start to disappear, and............

Not only this, the dollar rise is deflationary in its impact, so the fed starts to get nervous, so...........

Just how highly stung everything is can be seen from the treasury and mortgage interconnect. The fed genuflects one way, and down comes the treasury market sending up long rates and choking the recovery, the fed genuflects the other, and everyone gets busy buying treasuries waiting for the unconventional tools. Well you wanted to know why I think the game isn't over: now you have it.

Europe on the Japenese Road Map


Strong article from Anatole Kaletsky this. I wouldn't go along with his tongue in cheek optimism about the UK and the US, but on the danger of what he calls the media cliché of Germany being the prinicipal deflation candidate (I think you will find I was saying this here and on Bonobo Land long before it became fashionable to do so) I think he is bang on target. Also exceptional is his recognition that: "Cutting unemployment pay, reducing job protection and scaling back pensions can accelerate economic growth in an economy where demand is growing. But in an economy suffering from long-term demand stagnation, even the talk of such harsh supply-side reforms is likely to damage consumer confidence and further undermine demand." This is a point - like voices in the wilderness - Eddie Lee and I have been trying to hit home for some time. The srtuctural reforms are necessary, but everything is timing and mix, and if you don't get these right you're more likely to sink Germany further than to do anything constructive. Germany is an ageing and apprehensive society:

Last week’s figures confirmed that the German, Italian and Dutch economies have all entered their second or third quarters of economic decline, and that the eurozone as a whole was stagnant for the ninth consecutive month, with most industrial indicators pointing to further weakness ahead.

Despite all this grim news, investors are bidding up share prices across Europe, Germany has been the best performing major stock market in the world this year and the euro remains cripplingly expensive against the pound, yen and dollar, not to mention the Chinese renminbi — as anyone who has been on holiday in Europe this year can attest.

This divergence between market behaviour and economic reality can have one of two consequences. Either the eurozone economy will soon start to perform much better than the present statistics are suggesting; or investors in euro assets will soon realise that they are caught up in another asset bubble in some ways even more irrational than the dot-com speculation of the 1990s or the bond bubble that imploded so spectacularly two months ago.


There are several reasons why the outlook for Europe today looks considerably worse than it did for Japan in the mid-1990s, when its economy lurched from cyclical recession to structural depression.

The first is the paralysis of monetary and fiscal policy as a result of the single currency project. The monetary response to economic stagnation in Europe is proving even more timid than it was in Japan.

The European Central Bank has consistently dragged its feet and aggravated the recession, to the point where investors actually expect an increase in European interest rate next year. Compare this to what happened in Japan after the yen shock of 1995. Japan had already reduced its interest rates to 2 per cent a year before the yen shock hit in early 1995. From that point on the Bank of Japan became much more aggressive, slashing three-month rates to zero in six months (see bottom chart). Does anyone seriously expect the ECB to act so decisively in the next six months?

Fiscal policy will provide even less support for the euroland economy. European budgets are already in deficit, and fiscal policy is prevented by the Stability Pact from playing an active stabilising role. Japan managed to avoid a deep depression in the late 1990s because government spending kept the economy afloat, providing a net stimulus of almost 1 per cent of GDP each year between 1995 and 1999.

In euroland, the fiscal stimulus will be nil in the next few years — even on the optimistic assumption that Germany and France continue to ignore the Maastricht treaty’s insane strictures to reduce budget deficits when they ought to be expanding.

Meanwhile, the euro has become almost as overvalued as the yen was in 1995. In fact export prospects for Europe are now even bleaker than they were for Japan in the 1990s. Japan’s net exports grew rapidly from 1996 until 2000, providing the economy with its main source of growth. But Japan was able to increase its trade surplus only because America was allowing its trade deficit to expand.

Combining the influences of fiscal policy and trade, we can see that Japan was saved from depression in the late 1990s by a widening of budget deficits and export surpluses, which added more than 1 per cent to GDP growth each year.

Europe now faces exactly the opposite macroeconomic outlook. The budget deficit will be stable at best and may even narrow, if governments are mad enough to follow the instructions of the European Commission and the ECB. At the same time, euroland’s current account will shift towards deficit by 1 to 2 per cent of GDP.

Thus Europe is carrying a much heavier handicap in the global deflation stakes than Japan did in the 1990s.

But what about economic reforms? Surely the Europeans are finally getting the message about deregulating labour markets, cutting taxes, strengthening competition and trimming their welfare states?

There are some grounds for greater optimism in this area, especially in Germany, where Gerhard Schr?der’s Agenda 2010 programme is proving surprisingly successful in introducing some modest labour market reforms. But structural reforms, in the absence of a positive monetary and fiscal policy, can be worse than useless.

Cutting unemployment pay, reducing job protection and scaling back pensions can accelerate economic growth in an economy where demand is growing. But in an economy suffering from long-term demand stagnation, even the talk of such harsh supply-side reforms is likely to damage consumer confidence and further undermine demand.

This is another of the key lessons from Japan. With an aggressively growth-oriented monetary and fiscal policy (of the kind seen in the US and Britain since the early 1990s) labour market reforms can create new jobs and win public support, but in the absence of a clear commitment from the central bank and the government to keep demand growing, supply-side reforms simply put people on the dole.

Yet in Europe, the institutions that created the euro have made the co-ordinated changes in monetary, fiscal and structural policies almost impossible, even if the reform movement starts to command strong political support. This is at the heart of the long-term economic problems faced by the eurozone.

Japan became a laughing stock in the last decade because of the inability of its politicians, bureaucrats and central bankers to agree on the economic reforms that were clearly required. But Japan’s challenge in creating consensus is nothing compared with the nightmare of creating co-operation among the warring institutions of the eurozone. The ECB is a far more independent central bank than the BoJ ever could be. The European Commission, even more than the Japanese bureaucracy, is a self-serving institution that pursues its own agenda, regardless of what elected politicians may say.

The eurozone has 12 governments, which between them include roughly 50 coalition parties, as against the single government (more or less) in Japan. This means that Japanese-style problems of fiscal, monetary and political co-ordination must be multiplied by 12 in Europe, or maybe raised to the twelfth power. Investors around the world are betting that Europe is suffering nothing worse a standard cyclical downturn and will soon recover to become the healthiest economy in the world. They could turn out to be right. But remember: that is what everybody thought about Japan in 1995.
Source: The Times
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An Unwelcome Fall in Inflation


Some extracts from, and a link to, the recent Ben Bernanke speech which has caused all the fuss. The implicit output gap argument seems sound enough to me, I also think he's right to trace the current disinflationary pressures backwards and look again at the productivity/inflation situation during the 'new economy' boom. What this effectively means is that the process of capacity expansion outstripping aggregate demand effectively started earlier. Now why was this? The conventional argument is the internet-driven bubble. But this only takes things back one more step: why was there so much liquidity swimming around?

What I don't see - in what I am now coming to call the 'Treasury view' (whether in its monetary or structural variants) - is any analysis or explanation of why we might be having this continuing weakness in aggregate demand. This, as I see it is the soft spot, or weak point in the argument.

Following Lindh and Malmberg I do have a rough back-of-the-envelope model that can handle this, based around demography, cohorts, and either (take your pick) the life cycle, or the permanent income hypothesis. Is there something I am missing?

This distinction between inflation that is positive yet too low and deflation is worth exploring for a moment. Although the Federal Reserve does not have an explicit numerical target range for measured inflation, FOMC behavior and rhetoric have suggested to many observers that the Committee does have an implicit preferred range for inflation. Most relevant here, the bottom of that preferred range clearly seems to be a value greater than zero measured inflation, at least 1 percent per year or so. Both the apparent tendency of measured inflation to overstate the true rate of price increase, as suggested by a range of studies, and the need to provide some buffer against accidental deflation serve as rationales for aiming for positive (as opposed to zero) measured inflation, both in the short run and in the long run. To the extent that one accepts the view that measured inflation should be kept some distance above zero, a very low positive measured rate of inflation (say, 1/2 percent to 1 percent per year) is undesirable and implies a need for highly accommodative monetary policy, just as would be required for outright deflation. The language of the May 6 statement encompasses the risks of both very low inflation and deflation. I suspect that for the foreseeable future, of the two, the risk of very low but positive inflation is considerably the greater. That is, inflation in the range of 1/2 percent per year in the United States in the next couple of years, though relatively unlikely, is considerably more likely than deflation of 1/2 percent per year............

A second set of circumstances in which deflation or very low inflation may pose significant problems is potentially more relevant to the current U.S. economy. That situation is one in which aggregate demand is insufficient to sustain strong growth, even when the short-term real interest rate is zero or negative. Deflation (or very low inflation) poses a potential problem when aggregate demand is insufficient because deflation places a lower limit on the real short-term interest rate that can be engineered by monetary policymakers. This limit is a consequence of the well-known zero-lower-bound constraint on nominal interest rates. For example, if prices are falling at a rate of 1 percent per year, the short-term real interest rate cannot be reduced below 1 percent, since doing so would require setting the nominal interest rate below zero, which is impossible. (Likewise, the very low inflation rate of 1/2 percent would prevent setting the real interest rate lower than minus 1/2 percent.) Thus, in a situation of insufficient aggregate demand, deflation or very low inflation might prevent the Fed from achieving full employment, at least by means of the Fed's traditional policy tool of changing the short-term nominal interest rate.........

the factor most likely to exert downward pressure on the future course of inflation in the United States is the degree of economic slack that is currently prevailing and will likely continue for some time yet. Although (according to the National Bureau of Economic Research) the U.S. economy is technically in a recovery, job losses have remained significant this year, and capacity utilization in the industrial sector (the only sector for which estimates are available) is still low, suggesting that resource utilization for the economy as a whole is well below normal. By conventional analyses, therefore, even if the pace of real activity picks up considerably this year and next, persistent slack might result in continuing disinflation.5

A highly simplified, though not quantitatively unreasonable, calculation may help. Let us suppose that economic activity does pick up in the second half of this year, by enough to bring real GDP growth in line with its long-run potential growth rate--roughly 3 percent or so, by conventional estimates. Moreover, suppose that activity strengthens further next year so, so that real GDP growth climbs to approximately 4 percent, a full percentage point above potential. What will happen to resource utilization and inflation?

Focusing first on the implications for economic slack, we note that this projected path for real GDP gap would imply no change in the output gap through the end of this year, followed by a percentage point reduction in the output gap during 2004. Given the average historical relationship between the change in the output gap and labor market conditions, known as Okun's Law, the unemployment rate would be expected to remain at about its current level of 6.4 percent through the end of the year and then decline gradually to about 6.0 percent by the end of next year. This projection is fairly close to many private-sector forecasts.

Let us turn now to the implications for inflation. From 1994 to 2002, core PCE inflation remained in a stable range while the unemployment rate averaged about 5 percent; so let us suppose, for purposes of this example, that the unemployment rate at which inflation is stable is 5 percent. (If the unemployment rate at which inflation is stable is lower than 5 percent, the disinflation problem I am discussing becomes larger.) A little arithmetic shows that this scenario involves 1.9 point-years of extra unemployment (relative to the full-employment benchmark) between now and the end of 2004. Now make the additional assumption that the sacrifice ratio (the point-years of unemployment required to reduce inflation by 1 point) is 4.0, a high value by historical standards but one in the range of many current estimates. Then the additional disinflation between now and the end of next year should be about 1.9 divided by 4, or about 0.5 percentage points. So given our assumptions about GDP growth, core PCE inflation, say, might fall from 1.2 percent currently to 0.7 percent or so by the end of 2004.

The precise figures I have used in this exercise should be taken with more than a few grains of salt. But the bottom line (which would not be much affected if we played around with the numbers) is that, even if the economy recovers smartly for the rest of this year and next, the ongoing slack in the economy may still lead to continuing disinflation. So the FOMC's May 6 statement, by indicating both balanced risks to economic growth (that is, a reasonable chance of a good recovery) and a downward risk to inflation, had no internal inconsistency.

Now, further disinflation of half a percentage point in conjunction with a significant strengthening of the real economy would not pose a significant problem. But of course, the simple scenario I just outlined has risks. If the recovery is significantly weaker than we hope, for example, the greater level and persistence of economic slack could intensify disinflationary pressures at an inopportune time. Another possibility, given the uncertainty inherent in measures of potential output, is that the amount of effective slack currently in the economy is greater than most analysts think--which, if true, would help to explain the recent pace of disinflation.

There are good reasons not to discount this possibility. For example, during the late 1990s, economists worked hard to explain the combination of an unusually low unemployment rate and stable inflation--possible evidence of a decline in the economy's sustainable unemployment rate. Factors that were thought to have contributed to a lower sustainable rate of unemployment included the maturation of the labor force (Shimer, 1998); increased numbers of people on disability insurance (Autor and Duggan, 2002) and increased rates of incarceration (Katz and Krueger, 1999), both of which tended to remove less employable individuals from the labor force; improved matching between workers and jobs, facilitated by increased access to the Internet and the rise of temporary help agencies (Katz and Krueger, 1999); and perhaps other factors as well. Many of these forces continue to operate in today's economy, conceivably with greater force than in the late 1990s.6 In addition, measured labor productivity has continued to increase rapidly since early 2001--remarkably so, considering that productivity tends to be strongly procyclical--raising the possibility that we have underestimated the degree to which innovation and better use of existing resources have increased potential output. If so, the true level of slack in the economy is higher than conventional estimates suggest, implying that incipient disinflationary pressures may be more intense............


One more element of the model for inflation is important to mention: the error term. At the upcoming August meeting, the Board staff, as it always does, will present the FOMC with its forecasts for inflation. Based on historical experience (using actual staff forecasts for 1985-97), the staff's forecast for CPI inflation for the full year 2003 (that is, the current year) will prove fairly accurate; the confidence interval for that forecast, as measured by the root mean squared error, will be only 0.3 percentage points. However, if history is a guide, the forecast the staff provides next month for CPI inflation during 2004 will have a confidence interval of about 1.0 percentage points, a fairly wide range. This amount of uncertainty is no reason to be defeatist about trying to forecast inflation but it is a reason to be cautious. We are currently in a range where undershooting our inflation objective by 1 percentage point is more costly than overshooting by 1 percentage point. All else being equal, that fact should put us on our guard against unwanted further declines in inflation.
Source: Ben Bernanke Speech to the UCSD Economics Round Table
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Mind the Gap, One More Time

I don't know whether I'd go so far as Stephen Roach, who titles his latest MSGEF piece 'long live the output gap', since it's the existence of this gap that gives the strongest indication of the disinflationary pressure facing the US economy (perhaps I prefer the infamous 'mind the gap' of the London Tube). But quibbles aside, this piece from Roach is very timely and to the point:

Macro certainly has its moments in captivating financial markets. I suspect another one of those moments is now at hand. The debate over deflation has been given a new lease on life by Federal Reserve Governor Ben Bernanke. He has now set the risks of deflation squarely in the context of an “output gap” framework -- long a central tenet of macroeconomic analysis (see his July 23, 2003, speech, “An Unwelcome Fall in Inflation?” available on the Fed’s website). Using this macro construct, Bernanke has conclud?ed that even if the US economy now enters a period of solid recovery, the risks of deflation are going to be with us for some time to come. I couldn’t agree more.

Like most concepts in economics, the output gap is a complex restatement of a very simple premise -- the inflationary consequences of disparities between aggregate supply and demand. Alas, what always sounds simple in macro rarely is. Economists attempt to get at the notion of aggregate supply by assessing the growth of “potential” output (GDP) -- defined broadly as the sum of labor force growth and trend productivity. In essence, the output gap is then calculated as the difference between an economy’s growth potential and its actual level of aggregate a?ctivity. When output gaps are at “zero,” it’s the best of all worlds -- supply and demand are in perfect balance and, at least theoretically, the economy is at full employment and able to enjoy the luxury of a stable inflation rate. When demand exceeds potential -- a positive output gap -- inflation can be expected to accelerate. Conversely, shortfalls from potential -- a negative output gap -- are invariably associated with falling inflation; they reflect excess slack that gives rise to a phenomenon referred to as “disinflation.” As such, recessions are generally depicted as disinflationary macro events, while recoveries are thought to be inflationary.

As presented in this fashion, the output gap is all about levels of aggregate activity. This stands in contrast to the growth rates that color most of our impressions about the performance of economies. This is a critical distinction. An economy can be growing at, or even above, its potential growth rate and still have ample margins of slack capacity in labor and product markets; disinflationary pressures would prevail in such instances. Conversely, a fully employed economy growing slower than its potential growth rate would still be biased toward an inflationary outcome. In other words, initial conditions matter. An economy’s growth speed is not enough, in and of itself, to Idetermine the ups and downs of the inflation cycle. The verdict is critically sensitive to the state of resource utilization.

Which takes us to the case in point. In his latest speech, Fed Governor Bernanke has used this framework to make some important inferences about the economic and policy outlook for the United States. His most salient conclusion, in my view, is the premise that America’s output gap is likely to remain wide even in the face of a fairly vigorous recovery in the US economy. Bernanke comes to that conclusion by inserting a few key numbers into the o1995t gap framework. Operating under the premise that America’s potential growth rate is around 3%, he points out that even a 4% growth outcome in 2004 will not close the output gap for an underemployed US economy. In that context, a further deceleration in inflation can be expected. Inasmuch as inflation is already quite low -- averaging 0.9% for the core CPIU in the first six months of 2003 -- it’s that next leg of disinflation that becomes so problematic. While Bernanke celebrates America’s achievement of what he calls “the de facto equivalent of price stability,” that may not be a reason to jump for joy. In fact, it doesn’t take much of an imagination to envision what lurks on the downside of this threshold. On that basis alone, the Fed has good reason to remain vigilant in the fight against deflation -- even if the US economy now moves into a solid recovery mode, as the central bank and most other forecasters expect. And that, of course, is exactly the key conclusion that points to a protracted period of monetary accommodation.

Ben Bernanke is hardly alone in reaching these conclusions. Analysts at the OECD have come to the same realization. In their June 2003 assessment of the global economic outlook, OECD economists estimate that America’s output gap will hit 2.1% of potential GDP in 2003 -- the widest such shortfall in the US economy since 1991, when it rose to an nestimated 2.5%. Moreover, over the four-year period, 2001-04, the OECD estimates that the United States will record a cumulative output gap of 5.9% of potential GDP. That’s two full percentage points larger than the 3.9% widening of slack expected in the euro area and only fractionally below the 6.0% cumulative output gap expected in Japan, the land of deflation. Nor can the OECD be accused of sounding the “output-gap alarm” on the basis of an overly pessimistic growth forecast for the US economy. Their current prognosis calls for a 4.0% increase in real GDP in 2004 -- not unlike the outcome Bernanke has built into his stylized depiction of deflation risks. In other words, among the major economies of the industrial world, America is expected to be right at the top of the charts in feeling the full force of disinflationary pressures through the end of 2004. That’s obviously a new role for the unquestioned engine of the global economy.

Having said all that, it pays to take a deep breath and remember that this is macro -- not nuclear physics. The output gap analysis hardly provides an ironclad guarantee of deflation risk and the policies required to cope with such risks. As has long been noted, it is based on a number of heroic assumptions -- including, but not limited to, assessments of trend productivity, the inflation-stable? unemployment rate, and implied rates of full-employment capacity utilization. Moreover, the output gap construct is largely a “closed” macro model -- driven mainly by domestic considerations. In this era of globalization, macro models must be more “open” -- allowing for the possibility that aggregate supply curves are now global in scope. Not only is that true for tradable goods, in the form of Chinese-based outsourcing platforms, but it is now increasingly true in once non-tradable services, as exemplified by Indian-based IT-enabled service exports. In his latest speech, Bernanke concedes that the output gap could be considerably wider if aggregate supply curves were underestimated; in that case, disinflationary pressures would be even more intense as a result. The ever-increasing pace of globalization of goods and services suggests that is hardly idle conjecture.

Notwithstanding these important caveats, I think it pays to take the output gap seriously in assessing the risks of deflation. While the framework is hardly perfect, it provides a reasonably good assessment of the balance between aggregate supply and demand in the US economy. If anything, globalization tells us that the risks to this macro construct are tilted more toward an understatement of slack rather than the opposite. That points to a potential underestimation of theê intensity of disinflation, suggesting that it will take a lot more than a year or so of vigorous growth in the 4% vicinity in 2004 to end the current deflation scare for a low-inflation US economy. Conversely, it follows that any setback in the pace of recovery from the desired 4% trajectory would only widen the output gap even further -- intensifying the disinflationary pressures already bearing down on the US. Either way, the output gap is not about to disappear into thin air. And the longer it persists, there’s no escaping the bottom line for a low-inflation US economy -- the greater risk of deflation.
Source: Morgan Stanley Global Economic Forum
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