August 12, 2010
Persistent Large Output Gaps, Disinflation and Deflation
Or, what if the Accelerationist hypothesis doesn't hold. I'm sure this question will drive some apoplectic -- but I think it a reasonable question. First, let's look at the empirical evidence on what happens to inflation in the wake of persistent large output gaps. Fortuitously, Andre Meier has just written on this subject, in Still Minding the Gap:
This paper studies inflation dynamics during 25 historical episodes in advanced economies where output remained well below potential for an extended period. We find that such episodes generally brought about significant disinflation, underpinned by weak labor markets, slowing wage growth, and, in many cases, falling oil prices. Indeed, inflation declined by about the same fraction of the initial inflation rate across episodes. That said, disinflation has tended to taper off at very low positive inflation rates, arguably reflecting downward nominal rigidities and well-anchored inflation expectations. Temporary inflation increases during episodes were, in turn, systematically related to currency depreciation or higher oil prices. Overall, the historical patterns suggest little upside inflation risk in advanced economies facing the prospect of persistent large output gaps.
The author defines an episode of persistent large output gap (PLOG) as at least eight consecutive quarters of negative output gaps greater than 1.5 percent in absolute terms.
Figure 3 from the paper shows the impact of persistent, large output gaps on inflation.
Figure 3 from Meier (2010).
One of the differences between the 1980s and 1990s (and now the 2000s), is that the initial level of inflation is typically lower. That is, in the current episode, we are hitting the zero inflation rate threshold.  Figure 9 (in the paper) presents evidence that the extent of disinflation is less during the 1990's, which could be consistent with either greater central bank credibility, globalization, or nominal/real rigidities. I'll pursue this last line further (although the globalization hypothesis has been examined here).
Theory, and the World at Near Zero Inflation
Does crossing the threshold from disinflation to deflation change matters, and why? I think so, and here I'm guided in part by an important paper by (Nobel laureate) George Akerlof, Bill Dickens, and George Perry, entitled "The Macroeconomics of Low Inflation," Brookings Papers on Economic Activity 1996(1), pp. 1-76.
We demonstrate the prevalence of downward wage rigidity in the U.S. economy and model its significance for the economy's performance. Downward rigidity interferes with the ability of some firms to make adjustments in real wages, leading to inefficient reductions in employment. With trend growth in productivity near recent rates, as the rate of inflation approaches zero, the number of firms constrained and the degree of their constraints increase sharply, as does this inefficiency and shortfall in employment. The difference in the sustainable rate of unemployment between operating with a steady 3 percent inflation rate and a steady zero percent inflation rate is estimated as 1 to 2 percentage points in our simulation model, and 2.6 percentage points in the empirical time-series model. The main implication for policy-makers is that targeting zero inflation will lead to a large inefficiency in the allocation of resources, as reflected in a sustainable rate of un- employment that is unnecessarily high.
Some might argue that the behavior that we model characterizes a regime that will change, that a determined zero inflation policy would break down wage rigidity. We have several thoughts about this. We suspect that wage rigidity is deeply rooted, not ephemeral or characteristic of a particular set of institutions or legal structures, although these may well help to codify it and expand the relations to which it applies. The psychological studies that we cite treat as fundamental the notions of fairness and worker morale that appear to underlie nominal rigidity. Historical studies find downward rigidity present well before the existence of modern labor market laws and institutions, although whether to the same degree cannot be established from the available evidence. We observe that rigidity breaks down at the firm level when firms are under extreme duress, a condition that employees can observe and are willing to respond to; and we account for this behavior in our model. But this does not imply that rigidity in the aggregate is susceptible to a permanent regime change following analogous macroeconomic conditions. In the Great Depression, when extreme duress became widespread, downward rigidity initially gave way, but it did not break down permanently. Eventually laws and institutions were strengthened to reinforce downward rigidity. The idea that rigidity represents a particular regime that will disappear if the appropriate policies are sustained would seem to have the sign wrong.
In other words, those who think that once people just believe that wages and prices can fall, then wages and prices will miraculously become flexible, and the world will approximate a flex-price New Classical model, might be disappointed.
Even if one doesn't believe the Akerlof-Dickens-Perry model is relevant, the observed historical correlations in the Meier paper suggest that near term inflation is not the thing we should be worried about.
Are Things Different This Time Around?
What about the disappearance of central bank credibility, with large scale asset purchases? Does that qualify these conclusions? Meier writes:
The above considerations leave open how much longer disinflation might continue in the period ahead, but at least suggest limited upside inflation risk. Against this, one could argue that the current episodes feature some unique characteristics that might generate inflationary pressures beyond what has been observed in historical precedents. One often-cited argument relates to central bank credibility in times of unconventional monetary policies and strained public finances. Its proponents question the optimistic view of Dwyer et al. (2010), whereby monetary policy has reached a unique degree of credibility that will keep inflation closely aligned with official targets. Instead, they argue that central banks have lost credibility of late. The claim is closely linked to the large-scale asset purchase programs launched by several advanced country central banks over the last two years. Indeed, with disruptions in many financial markets and policy rates exceptionally low compared to most historical PLOG episodes (Figure 18) -- and often constrained by the zero bound on nominal rates -- unconventional monetary policies have become commonplace.
Some critics of these policies argue that, by expanding their balance sheets and issuing large amounts of base money, central banks have sowed the seeds of future inflation; see Meltzer (2010). In and by itself, this contention is not very convincing, as there is no obvious, let alone automatic, link from higher base money to inflation, provided that central banks maintain control over policy rates.19 Consistent with this, empirical studies have found central bank asset purchases to have had a positive effect on asset prices, while broad money growth has remained very subdued (Figure 16) and medium-term inflation expectations have shown no signs of becoming unhinged; see Gagnon et al. (2010) and Meier (2009).
There is, however, one important caveat to this benign view. Even if unconventional policies should work only through rather standard channels, providing no magical short cut to either full employment or high inflation, there is a tail risk that the public might develop a different perception. As Borio and Disyatat (2009) put it, "market expectations and beliefs [are not necessarily] consistent with the underlying transmission mechanism." Inflation expectations could rise sharply, in particular, if the public suddenly lost trust in the central bank’s capacity or commitment to maintain price stability, causing a self-reinforcing currency crisis.
At this juncture, I'll just note that the five year implied inflation rate (drawn from Treasury and TIPS yields) is declining. 
Another caveat is that we can't measure the output gap well. I think that is a challenge to the empirics (as noted in the paper), although I doubt using a different, conventional, measure of the output gap would overturn the results. For more on the issue of measuring output gaps, see:   .
Posted by Menzie Chinn at August 12, 2010 07:32 AMdigg this | reddit
Well, that all sounds swell! Apart from that damned tail risk.
I mean, why would the public lose faith in our majestic federal institutions? And what public? Those damned, ignorant gomers out in flyover territory? Sod them for model-denial!
Now we can ignore the gold price...
Posted by: C Thomson at August 12, 2010 08:05 AM
Yes because the gold price has a direct relationship to.... Hmmm... Actually over the past several months it has had something closer to a positive relationship to the dollar than an inverse one and an often inverse relationship with more reliable measures of inflationary expectations. If the Fed ever lives in fear of the gold market, one of the most profoundly irrational markets in existence, then I know that there is no hope. The ever and always shifting justifications for owning gold puzzle me to no end. The recent crop failures will not doubt be the latest fodder.
I think we can get a sense of consumers' and businesses inflationary expectations by their consumption patterns. Suffice it to say that the evidence there does not indicate a widespread fear of hyperinflation.
Posted by: Brian Quinn at August 12, 2010 08:40 AM
C Thomson: Well, as one of those people who lives in what you characterize as "flyover land," I think the empirical results presented by Dr. Meier make sense...
Posted by: Menzie Chinn at August 12, 2010 08:49 AM
One of the many afflictions common among macroeconomists is myopia.
JDH, to his great credit, does not suffer from this affliction. He recognizes that near-term disinflation does not imply that reckless fiscal and monetary policy will never result in future inflation.
Posted by: W.C. Varones at August 12, 2010 09:37 AM
Ah yes, gold is a barbarous relic that appeals only to the irrational like John Paulson.
And I so agree that there is no need to worry about anything until the model sends out an e-mail. In a rational world, who would think otherwise?
Except for those dratted fat tails. Where are the distributions of yesteryear?
Posted by: C Thomson at August 12, 2010 10:54 AM
Gold is having a good day, a good year and a good decade. Gold will be a stupid investment again as soon as that trend reverses.
Doesn't look good for municipal retirement funds missing their 8 percent compound return estimates by over 10 percent for the second year in a row. How might that respond to a PLOG?
Posted by: KevinM at August 12, 2010 01:39 PM
"JDH, to his great credit, does not suffer from this affliction. He recognizes that near-term disinflation does not imply that reckless fiscal and monetary policy will never result in future inflation"
Once again, how can monetary policy be "reckless" when it doesn't exist? You can't have inflation when a economy is stagnent and inflation is what we want along with falling private sector debts.
Keep on praying for your creditor based wealth transfers.
Thomson and Varones represent people who's patriotism is suspect and their intentions international quite explicit.
Posted by: The Rage at August 12, 2010 03:01 PM
Gold is all about fear, fear of complete collapse.
If liquidationism does become the long term reality, gold will surge even higher.
The problem with people like Thomson and Varones is they think higher gold=inflation protection. Nope, nada and no. Gold is protection from a complete collapse. Way worse than 1979 man. Why they post such nonsense makes them suspicious in my view and what their real aims are.
If the government had spent on investment and rebuilding of America's infrastructure, gold would be well on its way down with rising GDP and falling private sector debt. But the financiers and multi-nationals wouldn't be able to collect the rents so they poo poo'd it.
Posted by: The Rage at August 12, 2010 03:08 PM
Once again, we have an economics paper beginning with "This paper studies..." These three words make the paper producer-oriented (the author's perspective), not consumer-oriented (the reader's perspective). A producer-oriented paper risks mis-specifying the scope of the project and proving ultimately unsuitable for decision-making.
To show how, let's examine what the author does and how we might change it:
The author chooses 25 recessions in 14 advanced countries beginning in 1974. Why these countries and this time period? Is it to collect coefficients for general use in the profession? No, we find out eventually on p. 24 that he wishes to apply his analysis to the current recession.
OK, but are the selected 25 recessions comparable to the current one? Most of them, in fact, are not. For example, US monetary policy in the '81-'83 was specifically geared to wring inflation out of the system--very different from monetary policy today. And only a very few of the recessions chosen were financial crises resulting from asset bubbles. So the sample is unconvincing, in my opinion, for purposes of assessing whether the Fed's extraordinary actions during this recession will lead to inflation.
Now, had the first sentence of the abstract read, "Will Fed Policies Lead to Inflation?", Meier would have tackled the issue head-on. This is a consumer-oriented approach. How do we know? Because answering it implies an action item. This is a question that policy-makers would like answered. It is tackling a problem of interest to the reader.
What countries would one analyze to answer this question? Here's my pick:
- Zimbabwe, Argentina and the Weimar Republic: hyperinflation with an output gap
- Japan: deflation following a real estate bubble
- Sweden: economic shock following a financial crisis
- US Depression: asset price collapse after a bubble
All these recessions relate to inflation and output gaps--mostly in the context of financial or asset bubble-related crises. Note that some of these recessions (Sweden, Japan) overlap Meier's set, but many do not. And the focus is on fundamental analysis (identifying causal linkages) rather than technical analysis (statistical correlation).
So, had Meier posed the question directly, he would have specified the work differently, I think, and the action items would have risen right to the top (not to page 24). And his article would have been fascinating, I think.
Viewed from my perspective as a consultant with an appreciation for the beauty of economics, I am troubled by the striking lack of sophistication in the way many economists write and present. "This paper studies..." would not get you past the first year at McKinsey or Goldman Sachs.
Economics is a profession. It's time economists adopted the standards taken for granted by professionals working in other sectors.
Posted by: Steven Kopits at August 12, 2010 05:16 PM
Steven Kopits: What was the output gap in Zimbabwe, pre-hyperinflation? I would be very interested in finding out how that was estimated.
Posted by: Menzie Chinn at August 12, 2010 05:28 PM
I think your question proves Steven Kopits point.
We can't get the right kind of data on Zimbabwe to feed into our models, therefore it is irrelevant to macroeconomists.
Show me a model that has numerous observations of the bursting of enormous asset bubbles with record consumer indebtedness in a country with a fiat currency that is also the global reserve currency, a country with unfunded pension and health care obligations that are multiples of GDP.
By the time you build that model and wait for enough observations to make any conclusions about the future, we'll all be dead.
Posted by: W.C. Varones at August 12, 2010 05:38 PM
W.C. Varones: It's a serious question. I'm working on a paper that involves estimating potential GDP in LDCs/emerging markets. I'd like to expand my knowledge.
Posted by: Menzie Chinn at August 12, 2010 06:11 PM
The point I'm making, Menzie, is not about Zimbabwe. (However, it is fair to say, I think, that you can have a material output gap and hyperinflation.)
My point is broader, and I could have made it for any number of posts. I have nothing against Meier, per se.
When I was in graduate school, one of the problems I faced, and I saw that many graduate students faced, was selection of a topic for their thesis. Many of us struggled with the issue.
Little did I realize at the time that finding interesting topics was a skill, not a talent. It can be taught and learned, and I hope I provide a bit of insight into the methodology above.
I believe this is important to the profession. Based on what I've seen in Econbrowser, I am increasingly concerned about lack of sophistication in the economics profession in areas other than quantitative analysis. I see all sorts of life and death issues, and no economist seems to be covering them. Meanwhile, I see a plethora of papers which seem to be primarily about applying statistical methodologies without a deeper understanding of the fundamentals (that is a criticism of Meier), on the one hand, and excessive focus on what seem to be comparatively low priority issues, on the other. In my opinion, this occurs because many economists do not have good skills in identifying interesting problems. They were never taught the methodology.
As for the "this paper studies" syndrome: Meier's paper is deductive, not inductive. He starts with the general rule, and then its application. That's why the juicy bits start so far down (on p. 24). Further, by developing the tools first and then applying it, the tool is more general and blunt than if he'd started with the problem first, and then developed the tools to solve the problem. Meier's thinking is 'well let's look at the correlation of output gaps to inflation' (not an actionable item), but what he really wants to know is 'Is Fed policy going to cause unacceptable inflation?' (an actionable item). His tool, as it is not specifically designed for his purpose, is only partially useful. Put another way, he manufactures a can opener, but ends up opening a bottle of wine.
As a result, it's time-consuming and not entirely satisfying to read his piece. Just how much time do policy-makers have? The economics profession (as a whole, not necessarily all individuals) is under-selling itself because it still thinks life's about form or some sort of historical protocol rather than facilitating decision-making. Today, time is valuable, and economists are--as a structural matter--failing to respect it. Further, they're wasting a lot of their own time and effort in the process, and most importantly, are depriving society of the full benefit of their skills and intelligence. There aren't that many economists. They are a valuable and scarce resource, and society needs them to be operating near their full potential.
Posted by: Steven Kopits at August 13, 2010 09:20 AM
I think that the FED is waiting to act because it has an ulterior motive:
Duiring Dec 1990, the reserve ratio for non-transaction (non-personal and time and savings deposits), was reduced from 3 percent to 0 percent. The reserve ratio on net euro-currency liabilities was also eliminated (reduced from 3 percent to 0 percent).
Then, in April 1992, the reserve ratio on transaction accounts was reduced from 12 percent to 10 percent.
These legal reserve requirements were reduced or eliminated because "LENDERS HAD ADOPTED A MORE CAUTIOUS APPROACH TO EXTENDING CREDIT". This caution was exerting a restraining effect on the cost and availability of credit. To some types of borrowers. By reducing depository funding costs and thus providing borrowers with easier access to capital markets, the cuts in reserve requirements were designed to put the banks in a better position to extend credit.
In particular the cut to the requirement on non-personal time deposits was aimed directly at spurring bank lending because these accounts are often used as a marginal funding source. Of course it was recognized that some, but not all, of the benefits stemming from reserve requirement cuts would likely be passed, over time, to borrowers and lenders.
Under Public Law 109-351-OCT. 13, 2006
On October 1, 2011 the Financial Services Regulatory Relief Act of 2006
(under the "increased flexibility for the Federal Reserve Board to Establish Reserve Requirements) states in Section 19(b)(2)(A) of the Federal Reserve Act (12 U.S.C) 461(b)(2)(A) is amended:
(2) in clause (ii), by striking "and not less than 8 per centum," AND INSERTING "(and which may be ZERO)".
Posted by: flow5 at August 13, 2010 11:23 AM
3 cheers for Steven Kopits. He has put his finger on an issue that is critical to improving economics as a profession (as in: uses proven standards, gets predictable results), though most economists will not take him seriously because he proposes huge changes to the status quo.
Both McKinsey and Goldman Sachs are organized around clients. Specialists of all sorts are important, but are brought into any activity by a client oriented person who is solving a specific problem for a specific decision maker. If economics were taught this way, it might structure teaching programs for: corporate decision makers, local state and regional, national with sub-specialties in financial and all other, and international. A decision focus is the way top level MBA schools organize their teaching programs -think case studies, strategy courses, and integrative games / competitions. An MBA grad often has a functional degree, eg. sales, but at top schools, they have been through a broad, integrative teaching program. Economics schools need to seriously consider the requirements to make their students members of a profession - using standard tools for predictable results that are of interest to specific decision makers with well defined problems.
Posted by: Mike Laird at August 13, 2010 03:08 PM
SK at 5:16 PM.
Good points. I find it exasperating that econometricians are still comparing the current episode with post-war experience in hopes of gaining insight. At best a waste of time, at worst very misleading. Trying to normalize for the differences is simply too hard. A classic case of the drunk and the lamp post.
Posted by: don at August 13, 2010 03:13 PM
Kopits for Fed Chief! Until we abolish it!
Posted by: W.C. Varones at August 13, 2010 04:31 PM