An important concept when discussing inflation is that of Potential GDP; also referred to as “trend GDP”. Potential GDP is a measure of the US’s maximum productive capacity. If the economy is at productive capacity, then unemployment is low, capital is highly utilized and people are employed in jobs that best match their skills. Under such conditions we would expect GDP to grow at a fast clip; we’d be making more, better things without increasing inflation. The last statement is critical.
The Relationship Between Output and Inflation
Consider the situation of an economy at its potential. Factories are producing goods as quickly as possible, hiring more workers to make those goods, and unemployment is low. Consumers are purchasing goods as quickly as they are produced; buying homes, going out to eat and generally enjoying the boom. If suddenly we inject additional cash either through monetary stimulus or via a large budget deficit in an attempt to further reduce unemployment, then we will fail. The economy is running full bore and we can’t produce additional homes, dining experiences, or tickets (at least not in the short run). We have more money chasing the same number of goods. In such circumstances inflation is inevitable.
Now consider the opposite situation where the economy is running below potential like during a recession. In this case, producers are making far fewer goods than they are able, and consumers aren’t buying. Capital and labor resources are not being utilized and unemployment is high. In this situation we would expect inflation to decline substantially (and possibly go negative, a situation referred to as deflation).
The charts below depict GDP and Potential GDP along with the change in the Personal Consumption and Expenditures (PCE) Index since 1998. We observe that at times GDP has drifted above or below potential. In periods of deep recession like 2008 the damage is long lasting and it wasn’t until as recently as 2018 that US productivity fully recovered. We also see this same pattern reflected in the PCE data. Recall that the Fed’s stated target for inflation is 2%. For the period of 1998-2020, US GDP often ran below potential and, consequently, we observe PCE inflation running below the Fed’s 2% goal for most of the 2000’s and basically all of the 2010’s.
The coronavirus and the subsequent economic fallout has pushed US GDP (and the world) vastly below potential. It will likely take the better part of this decade (or longer) for the recovery to return us to where we were just a few short months ago. Thus, in the near term we can expect either a very benign inflationary or possibly deflationary environment.
The Outlook for Inflation
The specifics of our current situation and the ongoing fiscal and monetary response are worth pondering as we consider the likely path of inflation in the next 2-5 years. Normally, the government and Fed would be justified to deficit spend and expand the money supply to return the economy to operating at potential. Inflation would not be a problem because we have excess capacity to soak up. But there’s a twist…right now we don’t have any interest in getting back to potential.
Significant portions of the economy have been shut down and are likely to remain so for some time. Our true productive potential is now much lower because we aren’t allowing factories, restaurants or stadiums to open for business. Yet the government and Fed are conducting record shattering policy ops to try and float us along until another plan emerges. We now have vastly more money chasing a reduced set of goods.
To be clear, I’m not calling for a hyper-inflationary environment. The more likely outcome is an economy with above average inflation (> 2%) for a prolonged period of time. Furthermore, the link between money growth and inflation is non-linear; expansion of the money supply does not necessitate inflationary pressure. But in decades of monetary experimentation we have never seen this much money printing as the below graph of the change in M2 demonstrates. When combined with a reduced potential GDP, I think the stars begin to align for a resumption of inflation.
Conclusion
To summarize:
- In the near term (~12 months), the shock from coronavirus will be disinflationary. The tremendous loss of jobs and uncertainty will keep incomes constrained and spending muted; we will likely see an increase in the savings rate over this period of time.
- Lockdowns and social distancing measures constrain productivity and limit the Potential GDP of the US. Coupled with inventory draw down and rapid money supply growth inflation emerges with a lag (~12-24 months) and runs above target (>2%) for a sustained period of time.
- Longer term (5 years), there is the risk that prolonged +$1T Federal budget deficits create the need for debt monetization by the Federal Reserve. Inflation increases nominal US GDP, increases tax revenue and reduces the real burden of debt. Monetizing the debt would be a risky move for policy makers, but the combination of unhappy Congressional leaders and an unhappy electorate, I believe, increases the risk of using the printing press as a policy alternative.
Until next time, thanks for reading!
-Aric Lux.
