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.

  • housam jarrar

    I do beg to differ with your analysis that inflation expectations have not been under-estimated.The measurement of inflation by using rental inflation rather than the actual increase of home values definitely has contributed to a screw in the data and its representation.For an average joe like myself seeing home values move into the territory of unaffordable along with the doubling many times over of energy prices over the past 8 years should have moved inflation into a much higher bracket and yet it did not.The way inflation has been calculated seems to indicate to me that it does not reflect the reality on the ground and therefore should have alerted the feds to the possibility of deflation down the road which is the rut we are currently facing.Interestingly,if you adjust GDP to a more realistic inflation measure it would not be a shocker to realize negative GDP has been around allot longer than only the past quarter.

  • MattYoung

    Or underestimating its potential.

    It could be the case that a much more efficient set of market structures are emerging, but barely distinguishable by the banks. Hence investers are confused, thinking they are seeing skewed sector markets when in fact they are seeing one market constellation weaken and another strengthen.

    In this case, the total perceived volatility would be greater than the separate volatilities of each equilibria alone, and the whole market structure would be underpriced.

  • The lack of credit has sharply reduced potential output in the global economy. The trend output must be lower. Companies are struggling to get credit for simple things like Letters of Credit. I do not have statistics to hand but that must have an impact.

    in better news http://ftalphaville.ft.com/blog/2009/01/12/51016/are-things-really-that-bad-in-china/

  • “The measurement of inflation by using rental inflation rather than the actual increase of home values definitely has contributed to a screw in the data and its representation”

    Huh? The CPI index measures the cost of goods and services. The increase in “implied rental” is the service associated with a house. Inflation measures aren’t supposed to track changes in asset prices (which are related to expectations about the future). Including asset price inflation would make the CPI a less useful statistic – at least for what we actually use it for.

    “Hence investers are confused, thinking they are seeing skewed sector markets when in fact they are seeing one market constellation weaken and another strengthen”

    I suppose the question would be here – what market is not becoming relatively more productive?

    “The lack of credit has sharply reduced potential output in the global economy. The trend output must be lower. Companies are struggling to get credit for simple things like Letters of Credit. I do not have statistics to hand but that must have an impact.”

    Completely agree – this is how I have felt for a while. Although some recent data seems to indicate that, for New Zealand at least, a growing output gap is becoming important.

    In hindsight what has happened will be obvious – but without real time data things are a pain!!

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