November 21, 2003

The Output Gap and Equilibrium Real Interest Rates

I do not understand Morgan Stanley's Richard Berner:

Morgan Stanley: ...The output gap is the difference, in percentage points, between the level of potential and actual GDP, and as such measures economic slack.  It is a more comprehensive measure of the gap between actual and potential output than the factory utilization rate, which covers only about one-fifth of economic activity. Although many factors determine inflation — including inflation expectations, supply and demand shocks, and unit costs — other things equal, this slack in the economy tends to depress price change.  Currently, the output gap is wide; three years of subpar growth have opened up the gap to about 2% (that it is not wider reflects our belief that growth outstripped its potential in the 1990s boom, pushing the gap into positive territory, and the fact that the recent recession was the mildest in postwar history)...

But... But... But... if output was well above potential in the mid- and late-1990s, why wasn't inflation rising faster? "Output above potential" has to mean strong upward pressure on the rates of increase of wages and prices, or it means nothing at all. And if the economy was roughly at or slightly above potential in the late 1990s, slow output and rapid trend productivity growth since would mean that the output gap is now rather large.

But then Berner starts making a lot more sense:

 

...While the output gap is probably smaller than those following most postwar recessions, its true size is uncertain.  Recently soaring productivity has raised the possibility that potential growth is higher, that the gap is wider, and thus that disinflation risks are higher than anyone thought.  Labor productivity in nonfarm business accelerated to a 5.4% annual rate over the past two years, a pace not seen for four decades.  In my view, much of this pickup reflects the time-honored cyclical pattern of productivity improvement when the economy accelerates, lately magnified by the purging of hiring excesses of the bubble years. But some may well represent improvement in the trend.  If potential growth turned up to 3¾% in 2001 and stayed there, the gap would now be 170 basis points wider.  Not only might the gap now be wider, but if those favorable productivity trends continue, even 5% sustained real growth would only close the gap slowly.  Uncertainty about trend productivity growth past and future and about the size of the output gap argues for a continued asymmetric inflation risk assessment until clarity emerges.

Although his use of the phrase "continued asymmetric inflation risk assessment" makes me think that Berner would do very well if he were to move to the Federal Reserve.

All this leads up to Berner's conclusion that (i) the Federal Reserve is going to take its time before it starts raising interest rates, but when it starts it will raise them fast and far. The output gap will have to close significantly before the Federal Reserve starts raising interest rates (an unemployment rate below 5.25%?), but when it starts raising them it will want to get them back to a "neutral" posture relatively quickly:

...Taylor rules suggest that as the output gap closes and inflation rises toward its target, policy should move back towards equilibrium, defined below.  The Taylor Rule is a formula that relates the Federal funds rate to the output gap and the gap between actual and targeted inflation (see John B. Taylor "Discretion Versus Policy Rules in Practice," Carnegie-Rochester Conference Series on Public Policy, 39, 1993, pp. 195-214).... Ironically, there’s a potential offset to that deflation-fighting stance.  Higher trend productivity growth, while pointing to lower inflation, also suggests higher equilibrium or natural real interest rates.  That’s because the real returns to capital should reflect trend growth plus a rate of time preference (to compensate investors for waiting).  Thus, the higher is the growth trend, the higher the real “natural” short-term interest rate.  Specifically, one Fed staff estimate suggests that the real Federal funds rate consistent with a neutral monetary policy is 3%, suggesting that the nominal Federal funds rate should go to 4% or more at some point (see Thomas Laubach and John Williams, “Measuring the Natural Rate of Interest,” FEDS Discussion Paper 2001-56, November 2001).  So once the Fed begins to tighten, investors may come to recognize that, even if the speed of adjustment likely will be gradual, the magnitude of the task ahead dwarfs consensus assumptions that any rise in the Funds rate for the foreseeable future will be modest...

Posted by DeLong at November 21, 2003 10:15 PM | TrackBack

Comments

One backwhorl in the Navier-Stokes of the economy's cashs' flows is that poor folks see governments giving more money to people paid to look after them, poor folks, and say "Oh, fuck, there it goes again."

This makes for non-voters and poor folks voting Republican. "There is only one sin, and that is despair," said the man who is now the Cardinal from Chicago, over a beer, back when I was in the church business.

Posted by: David Lloyd-Jones on November 22, 2003 03:27 AM

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"Md=P*L(R;Y)".I think it depends on wether Md gets negative or not.Now, P cannot remain const.

Posted by: Justin on November 22, 2003 04:28 AM

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For years I have constructed a monthly Taylor
rule index using the unemployment rate rater than
the output gap.

It is: funds = 7 + CPI growth - unemployment rate.

It was almost a perfect rule from 1958 to 1980, broke down under Volcker, and started working again under Greenspan. Of couse I first discovered it right before it broke down under Volcker.

It now says funds should be just over 3%.

Interestingly, it implies that Fed policy under Greenspan was almost the same as this mechanical
decision rule would have generated until mid-2002. This rule would have had fed funds bottom at 1.75% rather than going on down to 1%.

Posted by: spencer on November 22, 2003 06:08 AM

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"But... But... But... if output was well above potential in the mid- and late-1990s, why wasn't inflation rising faster?"

Couldn't one also ask why it is that if output is so far below potential now how come inflation isn't falling faster? It seems to be rather flat currently.

http://research.stlouisfed.org/publications/mt/page10.pdf
I don't know if these charts reflect the thinking of the Fed, but they indicate GDP being about 2.5% over potential in 2000, about 1.5-2.0% under potential a year ago, and only .5% under potential now. The Taylor rule chart indicates that according to the rule they are currently targeting 6-7% inflation, and have been targeting 4% since 2001. Since the chart also shows them targeting 0% from 1995-1998, I would like to know if anyone knows what the lag from targeting an inflation rate with Taylor's rule is.

Is it possible something has been preventing the effects of the output gap on inflation? Because there certainly were a lot of people getting double digit raises in 1999-2000. I remember news reports of labor shortages even at low wage levels. I don't know, maybe the situation didn't last long enough to change the inflation level. Inflation did respond to the job loss over the last few years, but it seems to have stabilized despite the unemployment. And this I think shows that that very low interest rates can raise the price level directly and prevent a GDP gap from affecting inflation. So perhaps this new strategy of the Fed, wait till the last minute and then change rates drastically, will change this thinking that a GDP gap automatically leads to big moves in inflation.

Posted by: snsterling on November 22, 2003 09:10 AM

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"That’s because the real returns to capital should reflect trend growth plus a rate of time preference " Huh ? In other words.
This is, of course, the real interest rate in balanced growth given that we know that the aggregate intertemporal elasticity of substitution is 1.

Huh ? Odd all credible estimates are considerably lower say 0.5 so the balanced growth real interest rate should be the discount rate plus twice the growth rate in other words should have increased twice as much as Berner says.

More to the point. What is going on here ? There is an interest in growth theory and, it seems, an model with intertemporal optimization. However, there is no particular problem with a particular model which does not fit the data, so long as a representative consumer is optimizing something.

Posted by: Robert on November 22, 2003 05:14 PM

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The Taylor Rule chart given at the link above is interesting.

Back when I took my econ courses monetarism was in the policy driver's seat.

Look at the plunge in the rate of money base growth from late 1999 through 2000, followed by recession a year later.

If those numbers don't fit Milton Friedman's prescription for "how to create a recession" as given in my old textbooks, I don't know what ones would.

Posted by: Jim Glass on November 22, 2003 10:04 PM

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- Is it possible something has been preventing the effects of the output gap on inflation? -

There has been deflation in the producer price index. There is stickiness to significant increases in prices of big ticket high demand products from houses to tuition to drugs.

- Look at the plunge in the rate of money base growth from late 1999 through 2000, followed by recession a year later. -

Should we then expect a continuing growth surge from here?

Posted by: anne on November 23, 2003 08:12 AM

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One wants to ask Jim Glass what the coefficients are on his regression of GDP growth on lags of base growth. Picking out the one anecdotal episode that fits one's priors is unscientific. Show us your RATS output Mr. Glass.

Posted by: PEmberton on November 23, 2003 11:03 AM

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Ain't no disgrace to be poor - but might as well be.

Posted by: Lachman Dave on November 25, 2003 02:47 PM

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Ain't no disgrace to be poor - but might as well be.

Posted by: Lachman Dave on November 25, 2003 05:08 PM

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The important thing isn't doing, but knowing how you do it.

Posted by: Hirsch Claudia on December 10, 2003 08:57 PM

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very nice site, greetings from germany

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