Thursday, October 15, 2009

How Big Is The Output Gap?

Macro Man has thus far avoided the great "deflation versus inflation" debate, at least publicly, for a couple of reasons. The first is that he doesn't think the outcome will be as black and white as many of the debate's participants; he suspects the underlying dynamic is heavily dependent on the velocity of money, and so he prefers to focus his analytical energies in that direction. Moreover, the tone of the debate has taken on a quasi-religious tone, which is rarely conducive to the sort of open-minded give-and-take that yields substantive results.

However, it's probably worth touching on some small aspect of the debate, as behind the scenes it seems as if the same is happeneing at the Fed. Don Kohn's recent speech highlighted the large size of the output gap, a view largely echoed in last night's FOMC minutes. Yet at a recent St. Louis Fed conference, Bank president James Bullard offered a somewhat contrary view-namely that the collapse of the bubble has eradicated some of the productive capacity of the economy, thus rendering the output gap smaller than commonly believed.

This is an interesting and important issue, not least because the Greenspan Fed's belief in a large output gap was a major factor behind the policy mistake of leaving rates too low for too long in 2003-04.

Macro Man must confess that he has some sympathy for Bullard's view. A quick look at US manufacturing capacity, for example, shows that it has actually shrunk over the past year. Not as much as demand for that capacity has, of course, but still....it's quite a telling sign. While there is no accurate official measure of the total capital stock, Macro Man has to believe that it has been depleted as well.
Of course, a counter-argument to the notion of a smaller "national" output gap is the fact that consumer-driven Anglo-Saxon economies have essentially outsourced their manufacturing capacity, so you need to consider the notion of a "global" output gap. Well, perhaps....but even then there is no assurance that there is a limitless supply of foreign-made manufactured goods. The UK and US in particular- deficit countries with weak currncies- have seen foreign makers of certain goods drastically reduce the supply of their wares.

One small anecdote- Macro Man is looking to replace Mrs. Macro's Volvo station wagon. He's got his eye on a few diffferent Audi models (Q5, A4 estate.) There is basically no inventory in the UK, and no intention on the part of dealers to replenish inventory, so all cars have to be made to order . If you're lucky, you'll get a new one in March or April....at the earliest. Meanwhile, the prices of used cars have unsurpisingly ticked higher as well. So much for the yawning output gap...

Yesterday's post examined certain relationships in international trade. Macro Man suspects that most observers would concede that China has become the United States' foreign manufacturer of choice. Given the combination of a) continued overcapcity in China, b) the ongoing relative paucity of demand in the US, and c) the steadiness of the USD/RMB exchange rate, it seems reasonable to accept tthat US import prices from China should be low and falling, right?

While it's certainly the case that import prices from China are still down year-on-year, intriguingly, the quarterly change in import prices has returned to zero. In other words, there is no marginal deflationary trend in US import prices from China. If (or rather, when) domestic inflation in China starts to rise, courtesy of PBOC's helicopter money-drop, it seems reasonable to posit that US import prices from China will begin to rise.

Whither that global output gap?
So it was with great interest last night that Macro Man read of the divergence of views on the FOMC. One member wanted to reduce QE by not buying the full slate of MBS. AT least two voters, on the other hand, wanted to increase QE- despite the bounce in the data and the uber-rally in risk assets.

Now that the world is no longer coming to an end at the speed of light, it seems as if the Bernanke Fed is reverting to its original communications philosophy (i.e., members will be allowed to speak their own minds rather than toe the party line.) Given the disparity of views on the committee and amongst non-voting regional presidents, this seems likely to enegender a fair amount of volatility.

That the balance of opinion last month leaned towards more, rather than less, QE, could well introduce more of a risk premium into US markets. The curve has stepeend quite a bit in recent days as flatteners have been taken off.
At the same time, the dollar is once again on the back foot (even falling against sterling this morning!), as it should be given the quiescent attitude towards expanding QE. Ultimately, of course, the free lunch of dollar weakness may prove to have a bill, after all. That the oil price is threatening to break out of its recent range is perhaps an ominous signal; if inventories show a decent draw this afternoon, it could be off to the races.

And once again, the market will be left to wonder how big the suposedly yawning (energy) output gap really is, at least in the short run....

25 comments:

Nemo Incognito said...

Viz China, its interesting to note that they are desperately trying to close that output gap in steel and aluminium. In most other sectors it doesn't seem to have that much slack.

Anonymous said...

The US and UK thanks to their fiscal position can look forward to stagflation. Higher growth economies will move through to inflationary growth. The bottomline is one type of economy will get real returns on investments and the other type under stagflation won't. That's the bill to be paid for loose monetary policy going into and coming out of this GFC and we're already seeing it setup through currency adjustments.

Anonymous said...

I might add to that post with the simple observation. Why is money chasing high yields ? Because we already know what is waiting for us ahead on returns nullified by depreciation in our currency.

Anonymous said...

a macro man (or gurl) should look at the composition of imports. also a macro man (or gurl) should know import prices are down 15% yoy (granted before latest oil jump). given all this, nothing will happen before (or unless) VAT introduction, which a macro man (or gurl) should know pelosi started to stirr shit about.

dblwyo said...

MM - in the spirit of open-minded debate rather than religious shibbolethery :) might I suggest:
1) quite right on the velocity issue - dropping like a rock
2) Bullard also said we won't raise rates until GDP grows and Unemployment begins to improve significantly (not the interpretation that most put on his statements)
3)Greenspan didn't leave rates low to long according to the problems with Employment not to mention a small war; plus there was the notrious long-end conundrum; cf. this Macroblog post:
http://macroblog.typepad.com/macroblog/2009/10/reviewing-the-recession-was-monetary-policy-to-blame.html
4)in any case US inflation was due almost entirely to the importation of said inflation via energy prices not domestic cost pressures which in turn
5) was caused by S/D imbalances because of under-investment in aging fields and political inaccessibility of news ones plus the escalating demands of the REE. If China/Inda don't grow as fast will D>>S and have as big an impact? Possible but not as likely imho
6)at the intermediate term and beyond all that changes the $ debate as well.

bsanchez said...

"the underlying dynamic is heavily dependent on the velocity of money, and so he prefers to focus his analytical energies in that direction" ...

Indeed, very interesting things are happening on US M2 measure that I don't fully understand. If you look at six-monthly change rates M2 in March was growing at the fastest rate (over 9%) since the beginning of the weekly series in 1980. Success for QE and risk of inflation, some would say.

But since then growth has stagnated, and the fall in the last two weekly observations, although small (1.3%) is still the largest since the beginning of the weekly series. So the impact of QE has been temporary and very small. We are still faced with the prospect of deflation, others will say.

As you, I don't claim to know which way this is going. If you are interested in seeing the data I refer to above I have plotted it in my most recent post or you can create your own from the Fed's FRED2 online database.

Anonymous said...

Here's a question :

What does Gold trading at an all time high tell you about the fate of the dollar and the inflation/ deflation debate?

Anonymous said...

is there anything more gay in this world than a central banker?

is there anything more gay than moaning in code as if the message is destined only for the chosen ones? who are they kidding at this point?

and is there anything more gay than grown up men reading and compare statements issued by said gay central bankers, and if a comma is missing they think they discovered the holy grail of wealth?

if there is I'd like to know.

Macro Man said...

Using the word "gay" on a finance message board probably qualifies....

MarcoPolo said...

Macro Man seems to have missed important parts of the dynamic. Car sales are down by half. Unit costs are up correspondingly. Volvo cannot sell your wife a car below cost. Whether or not Volvo has cut capacity is a bit more nuanced. The labor that bolts bumpers on a Volvo is strictly variable. Turn it off, turn it on as demand requires. But there are other human capital inputs that take longer to train and install. So, it’s hard to know if capacity is down. The important thing is capacity is still way over demand.
Concede China has been the manufacturer of choice. Also a), b) & c) though import prices may not fall for the same reason as in the case with Volvo. China works on tiny margins. You should not be surprised there is a limit to the fall.
Not sure what that means to FOMC & MBS. Output gaps wouldn’t seem to be directly related to those prices. $ is a confidence game. IMO the FOMC should be looking at the perceived value of the $ relative to anything other than yuan as their single indicator.

Macro Man said...

Anon @ 12.57: those y/y declines are last year's story. The actual import price index is at its highs on the year.

dbl, 3Q03 real GDP rose 6.9%(and was released at the time up 7.2%)and Q4 rose 3.6% (initially released as 4%.) At the same time, the dollar got clumped...hard. It was obvious at the time that policy was too easy (which many people observed at the time), but Easy Al weighted til the end of 2Q04 to move rates, and then moved in only the tiniest increments.

The conundrum was a different issue- that was the product of FX reserve accumulators buying UST with their dollar purchases (the BOJ alone bought the best part of $150 billion in 1Q04 ), an effect that Greenspan singularly failed to observe (there's nary a mention of this phenomenon in Age of Turbulence, for example.)

In the parlance of today's yoof: Fail.

Ian said...

MM - UK car prices still eyewatering relative to the US?

Macro Man said...

Sure, because there's a 15% (soon to be 17.5%) VAT on them. Marco Polo, for a number of cars, slightly used vehicles are trading at or even slightly above list for new models, and premium used cars are up 10-15% (at least!) over March prices.

The problem is that it is uneconomic for foreign makes to sell cars here at prices that prevailed when €/£ was at 0.73....so they have curtailed supply. The only way supply will return is if prices go up...by a lot. While the manufacturer might feel like there's a big output gap, to the UK consumer (and, eventually, policymakr), it's an illusion.

dbl, my "Fail" in the previous post was directed at Easy Al, not you, btw.

MarcoPolo said...

MM, "The problem is that it is uneconomic for foreign makes to sell cars here at prices that prevailed when €/£ was at 0.73...."

Yes. Got ya.

Joe said...

MM -

Go with the Q5. The wife and I picked up one of the first wave to hit the shores here in the US, and we've been thrilled with the performance, mileage, fit, finish, etc. We traded in a Q7 for the Q5, and the difference is remarkable. Audi is doing great work at the moment.

Crisis Management said...

MM, nothing says I love you more than a 12.5kg gold bar "off the shelf" from Harrods to go with that new car.

Anonymous said...

Oil's broken out.Been consolidating for 3 to 4 months while the dollar went down the toilet so not expecting it to stop going up soon.

Anonymous said...

MM, so why don't they put up the price of their cars in the UK? It seems bizarre to keep prices unchanged and then refuse to ship anything because it's unprofitable.

Macro Man said...

Cars are already frickin' expensive, not only in absolute terms but also indirectly, via insurance/petrol duties/road tax/etc. I think at these levels the price elasticity of demand is quite high for most vehicles...or at least the income elasticity of demand.

Anonymous said...

What I do know is loose monetary policy is going to get seriously tested by energy this winter. Seasonality going to be stood on it's head like much other seasonality this year.

Let's just see how much energy inflation they can take.Watch for Asian currency pressures.

Anonymous said...

the YOY change in capacity utilization doesn't actual mean anything - you need to look at the level.

Macro Man said...

That chart is the change in total capacity, not capcity utilization.

Anonymous said...

There is basically no inventory in the UK, and no intention on the part of dealers to replenish inventory, so all cars have to be made to order . If you're lucky, you'll get a new one in March or April....So much for the yawning output gap...


this partially xplains the spike in the new orders and lead components in the PMI and other indices. inventories were run down to zero it seems . The output gap is still there. lots of underutilised swedes and factory capacity in torslanda, Göteborg (if you're going for the volvo) but take Audi.

dblwyo said...

MM - my data had 3Q03 REAL gdp at 2.9% then 3.8, 4.1, 4.0 while Employment was at -.3,-.1,.4 and 1.1%, peaking at the end of 2004 at 1.6% yoy. That's a pretty large difference. Mine is straight from the BEA web site. In any case hindsight might suggest tightening but there was a war if you'll recall, and employment stayed very weak. Going back to that Macroblog post that would suggest that policy was pretty much following the Rule, wouldn't it?
p.s. - your correction on Fail makes me feel much better :)

Macro Man said...

My rates are quarterly saar rates....yours look very much like y/y, which include base effects. The war "proper" was well over by 3Q03, as "Mission accomplished" was declared on May Day of that year.

In any event, the Taylor rule is itself based on the output gap concept; price trends in certain areas (such as housing) were pretty clear signals that policy was kept too easy for too long.