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August 28, 2009

Is the output gap showing?

In a recent speech, Atlanta Fed President Dennis Lockhart laid out two competing risks to the inflation outlook. On one side, the usual measures of economic slack (output gap measures) suggest that there is so much excess production capacity that prices and wages are under great—and increasing—disinflationary pressure. All this is occurring at a time when inflation measures are trending below the FOMC's longer-term projection.

The other inflation risk is that the public may come to believe that the combined efforts of the monetary and fiscal authorities to prop up a sagging economy will ultimately lead to a familiar place—rising inflation—and if inflation expectations begin to move higher, so too will inflation.

So the risks to the inflation outlook seem to pivot on two, potentially opposing, forces: downward price pressure coming from a weak economy and upward price pressure resulting from a skeptical public.

Lockhart's assessment is that these "inflationary and deflationary risks are roughly balanced." But in the end, the security of such an inflation outlook rests largely with the behavior of the inflation data. So it is important to continue watching carefully for any signs that the balance of these risks is tilting in one direction or the other.

This view brings us to a chart posted in last week's Economic Highlights showing recent trends in core goods and core services prices in the consumer price index (CPI).

082809a

A key observation to take away from this picture isn't the recent acceleration in core goods prices. The highly volatile behavior of goods prices tends to make them an unreliable guide to underlying inflation trends. Rather, it is noteworthy to consider the significant downward trek of core services price growth. Indeed, the 12-month trend in core services prices was a shade under 1.6 percent in July—its lowest reading in the post-WWII era and roughly 1¾ percentage points lower than this time last year.

Some of the downward pressure on core services prices is a direct reflection of the housing crisis; a little more than half the core services price components are computed from housing rents. But that's not the whole story as a rather sharp disinflation was evident in core services excluding rents.

082809b

Likewise, productivity-adjusted labor costs—so-called "unit labor costs"—have also recently turned negative. These aren't record declines, but they are well off their prerecession growth rates.

082809c

Is this a sign that economic slack has begun to show through to the retail price numbers? It could be a bit early to bet the ranch on that one. Nonetheless, the evidence seems to offer a pretty compelling story at this time.

By Mike Bryan, vice president and senior economist, and Laurel Graefe, senior economic research analyst, both of the Atlanta Fed

August 28, 2009 in Data Releases, Inflation, Monetary Policy | Permalink

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Comments

It's hard to keep up your pricing power when your competitor down the road is liquidating his inventory. And firing his workers. And the factory in town is closing. And the survivors are up to their necks in debt.

Inflation is a very real danger for any commodities that foreign governments can buy and ship out of the USA quickly (like food, art, gold, fish, etc)? An excessively vivid but perhaps useful analogy : look at the stuff that the Nazis raided out of Eastern Europe. Now imagine that they are using local currency (in this case, USD) instead of attacking with military force. There's the inflationary force.

The aggregate number is a perfect fake-out : citizens will be getting roasted by inflation on essentials while their wages (and the tax base of the government levels) crumble?

It is my opinion that there is a simple solution to all this mess but I am one of the many(?) who feel that current US fiscal and monetary policy is a road to total disaster.

A simple graph of nominal cost of hourly labor vs. nominal cost of food would be the one to watch, IMHO. That is what will shape the inflation expectations of the public?

Posted by: Namke von Federlein | August 28, 2009 at 10:13 PM

Mike - a short and clarifying discussion, thanks. A deeper question might be what engine did, could or might drive inflation. Lockhart and this have a traditional business cycle and domestic economy view it seems to me. I think the world has changed and the emergence of inflation, gradually, in '07 and '08 had more to do with the importation of inflation. To wit as China, et.al. were growing so rapidly the increased demands for oil, commodities and materials exceeded the existing capacity and drove up prices. They also triggered additional speculative premiums. That led to prices starting with PPI osmosing or percolating from the very front of the supply chain to the consumer facing side. We're still in a world of D>>S so the question is how big is the gap ? Which is really what will be growing forward growth rates ? China built an export-driven economy but in a newly frugal world US and other consumers won't be buying as much abroad. And certainly not financing it. So in a world of slow, painful and jobless recovery will we face just S>D or S~D ?
That might be worthwhile to investigate. It certainly changes the policy environment, and if these guess are right, aren't well-reflected in any discussions.

Posted by: dblwyo | August 29, 2009 at 08:00 AM

Interesting post. It's always seemed to me that it was problematic to speak of the inflation rate as single a single number. Right now, wage inflation would be good, commodity inflation bad. The loose money seems to be fueling a speculative rise in commodity prices, as household incomes are flat.

In the latest consumer poll by UMich, inflation expectations fell slightly, even though gasoline prices have been rising this month.

I'm not sure the falling rents should be attributable to the housing crisis and not the preceding bubble. Rental vacancy rates started rising as people left apartments to buy homes, but homebuilding increased faster than even this increase in demand justified and homeowner vacancy rates started jumping in 2005/6 and peaked 2008Q1.

Lower household formation has exacerbated what was already a large inventory overhang.

Posted by: Bob_in_MA | August 29, 2009 at 10:14 AM

How about a chart of "core services" CPI x "healthcare?"

Posted by: JohnnyB | August 31, 2009 at 09:28 PM

The term "output gap" suggests that there is idle productive capital and labor (not a HUGE assumption at this point). However, to jump from price level data to conclusions about the output gap could be hazardous, as both supply of goods/services, as well as demand for goods/services, determine the price level. Demand for goods/services has certainly fallen amidst shocks to household wealth and a general shift toward saving a larger percentage of household income. This demand-side effect might be just as strong an explanation, if not a stronger one, than inventory effects on the supply side.

A germane graph to investigate this query would focus on capital utilization and reliable measures of consumer sentiment

Posted by: fischer | September 02, 2009 at 10:44 PM

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