With the monetary authorities of major developed market economies implementing unprecedented levels of stimulus in lock-step, many investors are worried about inflation over the long-term.
In the near term, however, there seems to be a broad consensus that inflation will remain subdued. This view rests on two arguments. First, that GDP growth in these economies will remain sluggish; second, that there is a large “output gap” within developed economies. While we agree that demand may underwhelm in the coming quarters, we think forecasters may be getting it wrong when it comes to the output gap.
The output gap is the theoretical measure of the difference between what an economy is capable of producing and what it actually produces, or potential GDP less actual GDP. The problem with measuring the output gap is that it is entirely based on what assumptions are made about “potential output” – a highly theoretical measure.
To arrive at this figure, economists use pre-financial crisis GDP as a baseline and adjust it by inflation to arrive at a potential GDP figure. What this approach does not take into account is that during periods of prolonged economic downturn, certain unutilised capacity in the economy becomes permanently impaired or obsolete. Given the pace of change in technology and automation, a factory which has sat idle for some years usually cannot be brought back into service without significant capital investment.
More important is the effect of a prolonged downturn on the workforce. When workers with specific skills cannot find jobs using that skillset the majority either retrain for other industries or accept lower-skilled, lower-paying jobs. As such, when economic recovery sets in, companies not only need to make significant capital investments to increase capacity but also tend to struggle finding workers with appropriate skills. This inevitably translates into wage inflation which is a key underlying driver of prices.
We can see this playing out today with many CEOs bemoaning a shortage of skilled labour in a variety of business critical areas. This is in clear contrast to what economists are telling us about the slack in the economy.
In the 1970s the Federal Reserve overestimated the output gap, leading it to maintain overly loose monetary policy conditions for too long. As we all know, this ended with a prolonged and painful run of higher inflation. If the output gap is materially smaller than economists are forecasting, is there a chance we are on the same dangerous path today?