Richard Fisher and the Output Gap

I've been posting about this topic from time to time on Bonobo Land ), and about how our idea of a national output gap may be somewhat quaint and outdated in a globalised world. "The global output gap" idea of Borrio and Filardo is an interesting one. To a great extent I go along with Dallas Fed President Richard Fisher's argument that in a globalised world the idea of a national output gap is less and less relevant, but globally the idea makes much more sense. This also fits in with Andy Xie's methodological proposal that in macro terms we stop thinking about the global economy as an agglomeration of individual partially-open economies, and instead consider it one single 'developing economy' with a lot of regional market imperfections (home bias etc). Personally I find this idea makes a lot more sense.

You can find a good example of Fisher's speeches here:


The literature on globalization is large. The literature on monetary policy is vast. But literature examining the combination of the two is surprisingly small.

I believe globalization and monetary policy are intertwined in a complex narrative that is only beginning to unfold.

There are many convoluted definitions of globalization. Mine is simple: Globalization means economic potential is no longer constrained by political and geographic boundaries. A globalized world is one where goods, services, capital, money, workers and ideas migrate to wherever they are most valued and can work together most efficiently, flexibly and securely.

Where does monetary policy come into play in this world? Well, consider the task of the central banker, seeking to conduct monetary policy to achieve maximum sustainable non-inflationary growth.

Former Federal Reserve Governor Larry Meyer gave an insider’s view of the process in his excellent little book A Term at the Fed. It was one of the first things I read as I prepared for my new job. In it, you get a good sense of the lexicon of monetary policy deliberations. The language of Fedspeak is full of sacrosanct terms, such as “output gap” and “capacity constraints.” There is the “natural rate of unemployment,” which morphed into “the non-accelerating inflation rate of unemployment,” or “NAIRU.” Central bankers want GDP to run at no more than its theoretical limit, for growing too fast for too long might stoke the fires of inflation. They do not wish to strain the economy’s capacity to produce.

One key capacity factor is the labor pool. A shibboleth known as the Phillips curve posits that unemployment falling beneath a certain level ignites demand for greater pay, with inflationary consequences for the entire economy.

Until recently, the econometric calculations of the various capacity constraints and gaps of the U.S. economy were based on assumptions of a world that exists no more. Meyer’s book is a real eye-opener because it describes in great detail the learning process of the FOMC members as the U.S. economy entered a new economic environment in the second half of the 1990s. At the time, economic growth was strong and accelerating. The unemployment rate was low, approaching levels unseen since the 1960s. In these circumstances, inflation was supposed to rise—if you believed in the Phillips curve and the prevailing views of potential output growth, capacity constraints and the NAIRU. That is what the models used by the Federal Reserve staff were saying, as was Meyer himself, joined by nearly all the other Fed governors and presidents gathered around the FOMC table. Under the circumstances, they concluded that monetary policy needed to be tightened to head off the inevitable. They were frustrated by Chairman Greenspan’s insistence they postpone the rate hikes.

We now recognize with 20/20 hindsight that Greenspan was the first to grasp changes in the traditional relationships among economic variables. The former chairman understood the data and the Fed staff’s modeling techniques, but he was also constantly talking—and listening—to business leaders. And they were telling him they were simply doing their job of seeking any and all means of earning a return for shareholders. At the time, they were being enabled by new technologies that enhanced productivity. The Information Age had begun rewriting their operations manuals. Earnings were being leveraged by technological advances. Productivity was surging. Inflation wasn’t rising. Indeed, it just kept on falling.

Globalisation and inflation: New cross-country evidence

The header refers to the title of a paper by two economists at the BIS (and this paper was the reason I was rumaging around the BIS site and came up with my last post. Basically New Economist has the details in his post How has globalisation affected inflation?. Basically NE suggests that "this chapter (in the latest IMF WEO), How Has Globalization Affected Inflation? (PDF), provides "robust support for the global competition hypothesis", with greater trade integration and foreign competition seeing falling import prices. There have also been greater restraints on domestic price and wage growth in sectors more exposed to international competition, such as textiles and electronics. However "the direct effect of globalization on inflation through import prices has in general been small in the industrial economies". The IMF however do go on to qualify this:

That said, when global spare capacity increases—such as during the 1997–98 Asian financial crises and the 2001–02 global slowdown—import price declines have had sizable effects on inflation over one- to two-year periods, shaving more than 1 percentage point off actual inflation in some advanced economies.

Stephen Roach also has a post about the Claudio Borio and Andrew Filardo paper:

BIS researchers have recently extended this analysis, arguing that a “globe-centric” framework now does a much better job in explaining inflation than does the traditional “country-centric” approach (see Claudio Borio and Andrew Filardo, “Globalisation and inflation: New cross-country evidence on the global determinants of domestic inflation,” March 2006). Their major contribution is a careful construction of several alternative versions of a “global output gap” -- in effect, a measure of the difference between aggregate supply and demand for the overall global economy. In looking at a sample of 15 major industrialized countries, Borio and Filardo find that the global output gap does a much better job in explaining fluctuations in inflation of individual economies than does the domestic output gap. In other words, to the extent that there is slack in the global economy, inflationary pressures could well remain in check -- even for those nations that have run out of spare capacity in labor and product markets at home.

Putting it more formally, Borio and Filardo’s broadest measure of the global output gap -- a GDP weighted construct -- paints a picture of good balance between worldwide supply and demand in 2005. That stands in sharp contrast with earlier periods of cyclical excess when the global output gap tipped into the danger zone, with aggregate demand exceeding supply by anywhere from 1.25% (2000) to nearly 3% (1973). That’s not to say that that the global output gap will stay constructive in the years ahead -- especially if there comes a point when the growth dynamic in the supply-driven non-US world draws increasing support from internal demand. In my view, however, that day is still very much in the future. Consequently, with the global price rule still flashing an all-clear sign, the bond market may have a very difficult time pushing nominal long-term interest rates much above current levels.

Research on Deflation

Well, I'm back, after nearly two and a half years of absence, starting to limber up on the whole question of deflation again. Toady I thought about doing this after looking at this paper from two economists at the Bank of International Settlements: Claudio Borio and Andrew J Filardo, Back to the future? Assessing the deflation record. Here's the abstract:

The rhetoric of deflation has become more prevalent in policy circles and in the press despite the fact that deflation has been a rare phenomenon in modern fiat currency economies. To better understand the nature of deflation, this paper looks back to a period when deflation was a regular feature of the economic environment, across both time and a wide set of countries. One feature of the deflation record stands clear. During the 19th century and early 20th century, deflation was not generally associated with persistent and deep economic malaise. Most periods of deflation also appear to have been largely unanticipated, with interest rates rarely approaching their zero lower bound. One notable exception to this typical pattern was the Great Depression of the early 1930s, the event that nowadays colours current general perceptions of what deflationary episodes might look like. At the risk of oversimplification, one way to think about this broad sweep of history is that deflations come in three basic types: the good, the bad and the ugly. The paper then jumps forward in time, seeking to draw lessons from the past about the possibility of future episodes of deflation and their characteristics. In doing so, it pays particular attention to the similarities and differences in the monetary and financial regimes prevailing now and in the past. While great care should be taken in any such exercise, the paper concludes that certain features of the past can help to shed some light on the policy challenges that policymakers might face in the future.