Why The "Output Gap" Inflation Model May Be Fatally Flawed

Could it be that the fundamental economic indicator that is gospel not only to Goldman Sachs, but to Ben Bernanke in estimating and determining monetary policy, the output gap, provides a flawed reading of the economy? As a reminder, Ben Bernanke has repeatedly expressed little regard for either commodity inflation or US dollar exchange as having an impact on overall US inflation. As Askari and Hochain state: "according to [Bernanke's] theory, inflation was related only to the output gap. As long as the output gap was negative, that is, if actual gross domestic product was below potential GDP, the economy was at no risk of inflation. Hence, he argued that the central bank had to adopt an aggressive money policy until the output gap closed. Such is the policy prescription from what is called the Taylor Rule or the Phillips Curve. Because potential GDP is not a measured macroeconomic variable, it can be estimated in millions of ways. There are, therefore, millions of ways for estimating an output gap, making the concept difficult to use as a policy tool." The problem with these millions of estimations, is that especially courtesy of the Greenspan created bubble over the past 20 years, the American economy is, ironically, not a true representation of itself. And thus, the output gap estimates need to be normalized for a "bubble free" GDP environment. It is precisely this issue that none other than the St. Louis Fed addresses in its latest paper: "Has the Recent Real Estate Bubble Biased the Output Gap?" The conclusion is startling: based on a production function output gap normalization (an approach "based on a relation between available productive inputs (such as capital and labor), their current utilization rates, and aggregate production"), Bernanke could be fatally wrong about the economy's "capacity for inflation" courtesy of the CBO's overestimated output gap, and that his loose monetary policy could end up being a disastrous precursor to rampant (and not distant) hyperinflation, due to his blatant avoidance of simple logic when interpreting the economic output gap.

Some preliminary observations from St Louis:

The output gap is the difference between actual gross domestic product (GDP) and the economy’s potential output at a given moment in time. The Congressional Budget Office (CBO) estimates a very large and negative output gap for 2009’s second quarter: –6.7 percent. Because this (predicted) output gap is so large, several analysts have concluded that monetary policy can remain very accommodative without fear of inflationary repercussions. We argue instead that standard output gap measures may be severely biased by the bubble in real estate prices that, according to many, started around 2002 and burst in 2007.

Why is the output gap such a tricky concept?

One difficulty in estimating output gaps is that a key component—potential output—is defined as the GDP attainable when the economy is operating at a high rate of resource use. Because economies are subject to the effects of recurrent external forces, actual GDP is typically not at its full potential. This implies that we cannot really ever observe potential output and, hence, it must be approximated. The first method to do this consists of identifying potential output according to long-term trends in GDP. The second method—the production function approach—is based on a relation between available productive inputs (such as capital and labor), their current utilization rates, and aggregate production.

Here is the core of the issue, so obvious, that even first year investment banking analysts are taught to account for it, yet the Chairman of the Federal Reserve, due to the bubble of his own creation, is unable to grasp it.

Components of existing statistical methods to estimate potential output are typically subject to inertia. Hence, if the recent real estate bubble increased GDP and productive inputs to levels higher than what would be expected by economic fundamentals, then it is likely that potential output estimates will also be beyond what economic fundamentals would imply. Thus, these estimates would be biased. One way to better understand how bubbles affect key macroeconomic indicators is to consider that high growth in real estate prices may affect GDP not only through the increase in the value of residential services, but also through its indirect impact on higher than-usual growth in (i) the finance and insurance sector and (ii) consumption—the latter caused by perceived increases in personal wealth.

And the renormalization exercise:

Knowing the exact rate at which the economy would have grown without a bubble might be impossible. Nevertheless, we construct two estimates of potential output that we consider reasonable and “bubble-free.” These estimates are based on the long-run trends of GDP and capital stock up to 2002, before the bubble began. We call the difference between our artificial constructs and actual GDP our “bubble-free” output gaps. Our results are summarized in the chart.

Our output gap estimate based on GDP growth trends during the 50 years preceding the real estate bubble yields an output gap more negative than the CBO’s estimate. Why the difference? Growth during 2002-09 was relatively weak compared with the past 50 years. Notably, this estimate also has the undesirable characteristic of being sensitive to the period chosen to estimate GDP growth trends. In contrast, the output gap based on the production function approach, after adjusting the value of inputs for possible bubbles, results in an output gap less negative (and positive through 2008) than the CBO’s estimate. Hence, two reasonable methods yield opposite conclusions about the output gap. At the very least, we can say that the confidence intervals for the output gap seem to be wide.

And the sobering conclusion:

Our results add to a long list of practical problems in precisely measuring the output gap. We offer a word of caution to policymakers: Policies based on point estimates of the output gap may not rest on solid ground.

Keep in mind, this is not the conclusion of some liberal third party think tank: this is the Fed itself opining on the bubble of its own creation. And when the Fed says that Bernanke's $1.7 trillion policy of Quantitative Easing, almost guaranteed to be soon followed by a sequel (and another, and another), could have been based on a pro-cyclical reading of patterns, which in turn merely perpetuate the bubble, it is time for the lunatics in the Fed to finally take their feet of the printing machine accelerators and consider  the collision course they have set the US economy on. It is also time for Ben to reconsider his assessment of whether or not his actions over the past year have thrown us into yet another bubble. It would appear that we never even emerged from the original one.

Full St. Louis Fed paper.