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Wednesday, September 17, 2003

The Deflation Meter is Ticking Away

If the mood in the financial markets were anything to go by, the US recovery is a done deal. Why do I remain so skeptical? Because K says there's an Argentina type crisis lying in wait for us somewhere up the river? Not at all. This may, or may not happen, but it won't happen now. So why the doubts. Well of course there are the employment numbers (as long as you keep your mind off the headline spin and look at what is really happening). Then there is industrial production, which is definitely improving , but just not as much as everyone expected, or consumer sentiment which stubbornly refuses to improve, and seems bent on continuing its downward drift. Against this background, and the continuing strong growth in US labour productivity, yesterday's inflation numbers should hardly have come as a surprise: if we strip out food and energy the US inflation rate is hovering round the 1% mark.

Now let's remind ourselves, shall we, of what Federal Reserve Governor Ben Bernanke was saying back in July in his "An Unwelcome Fall in Inflation speech:

Within this framework for thinking about price dynamics, the factor most likely to exert downward pressure on the future course of inflation in the United States is the degree of economic slack that is currently prevailing and will likely continue for some time yet. Although (according to the National Bureau of Economic Research) the U.S. economy is technically in a recovery, job losses have remained significant this year, and capacity utilization in the industrial sector (the only sector for which estimates are available) is still low, suggesting that resource utilization for the economy as a whole is well below normal. By conventional analyses, therefore, even if the pace of real activity picks up considerably this year and next, persistent slack might result in continuing disinflation.5

A highly simplified, though not quantitatively unreasonable, calculation may help. Let us suppose that economic activity does pick up in the second half of this year, by enough to bring real GDP growth in line with its long-run potential growth rate--roughly 3 percent or so, by conventional estimates. Moreover, suppose that activity strengthens further next year so, so that real GDP growth climbs to approximately 4 percent, a full percentage point above potential. What will happen to resource utilization and inflation?

Focusing first on the implications for economic slack, we note that this projected path for real GDP gap would imply no change in the output gap through the end of this year, followed by a percentage point reduction in the output gap during 2004. Given the average historical relationship between the change in the output gap and labor market conditions, known as Okun's Law, the unemployment rate would be expected to remain at about its current level of 6.4 percent through the end of the year and then decline gradually to about 6.0 percent by the end of next year. This projection is fairly close to many private-sector forecasts.

Let us turn now to the implications for inflation. From 1994 to 2002, core PCE inflation remained in a stable range while the unemployment rate averaged about 5 percent; so let us suppose, for purposes of this example, that the unemployment rate at which inflation is stable is 5 percent. (If the unemployment rate at which inflation is stable is lower than 5 percent, the disinflation problem I am discussing becomes larger.) A little arithmetic shows that this scenario involves 1.9 point-years of extra unemployment (relative to the full-employment benchmark) between now and the end of 2004. Now make the additional assumption that the sacrifice ratio (the point-years of unemployment required to reduce inflation by 1 point) is 4.0, a high value by historical standards but one in the range of many current estimates. Then the additional disinflation between now and the end of next year should be about 1.9 divided by 4, or about 0.5 percentage points. So given our assumptions about GDP growth, core PCE inflation, say, might fall from 1.2 percent currently to 0.7 percent or so by the end of 2004.

So, to spell things out, Bernake is saying (and of course these calculations are not written in tablets of stone) that if things continue as they are at present we could be down to a 0.7% inflation rate by the end of 2004. And if the economy is a little weaker, and the slack is a little more, then naturally the disinflation will be greater. Since I don't see anything on the horizon right now that is going to turn all this round for the good (while there are plenty of factors which could help make matters worse) I think we have to imagine we might hit deflation in the US sometime around the end of 2004, beginning of 2005. That is why I don't buy the upbeat spin, and that is why I haven't been buying it for some time now.

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