Is the US overestimating its “potential”?

Over in the good old US the Congressional Budget Office has released their forecasts (ht Paul Krugman). It is an ugly sight, as would be expected, with growth falling miles below its “potential” level and a large negative output gap opening up.

As Paul Krugman points out, this type of large output gap would provide massive deflationary pressure – he suggests that we could have a deflation rate of between 3-5%!

Now, I’m sure his logic is spot on given this estimate of potential output – however this raises a question for me, has potential been forecast correctly? Generally, growth in potential output is forecast to be relatively stable – and trends along with historic growth. But this doesn’t feel quite right. There are two reasons why this may fail:

Inflation expectations turn out to be a extremely powerful behavioural anchor for price setting

If we have been running well above our long-term equilibrium level of output, this method could lead to a huge overestimation of potential.

If this is the case, the output gap that is being mentioned here – and being used to justify policy – may not exist (as the method used would overestimate potential)!

Once critique of this point of view would be “if we were running well above capacity why didn’t inflation explode”. Some would answer this by saying that inflation has been underestimated – but I don’t believe that.

Ultimately, we could state that inflation expectations have become strongly anchored. Outside of the “great moderation” we have never experienced “anchored” inflation expectations before – and so they may be a lot more effective at controlling inflation than we expected. If this is the case, we may have over-run capacity substantially, but the strong tool of inflation expectations was able to moderate inflationary pressures.

Of course, to test this hypothesis we need the otherside – we need output to fall sharply and inflation to remain near its anchor. If this does occur, then the idea of inflation expectations and method of estimating potential output will both need a bit of work.

Permanent shocks and moving potential

If we cannot buy the above hypothesis (which I don’t really) there is another one – we have faced a structural shock, and now our trend level of output is lower. If it turns out that the mythical output gap does not appear this is what I would lay down as the cause.

These is a view of the economy I am more confident of.  Although current fiscal policy in the US seems to be based on the idea that all the downturn is the result of a deviation from “potential” many analysts do believe that there is a “structural” element to the latest downturn – namely the amount of production that the economy can maintain has taken a shock.

An increase in risk avoidance (as people have repriced risk) and a breakdown in institutional structure are two of the main factors that I think could have caused a decline in how much the economy “can” produce.

Ultimately, I think that any forecasts that don’t take into account the structural nature of some of the shocks we are facing will overestimate the size of the “output gap” and will therefore overestimate the “disinflationary pressure” associated with that slowdown.  Furthermore, it would “overestimate” the need for some type of fiscal stimulus.