The global output gap
THE image at right is a graphic taken from Bloomberg's markets page, which shows four indexes of commodity prices. There are obviously more things influencing commodity prices, from drought in America to China's growth prospects, but what bugs out in this image is the overwhelming influence of perceptions of the euro-area crisis. A sustained rise begins in late 2011 on the heels of the European Central Bank's announcement of a plan to prevent a banking system meltdown, via €1 trillion in short-term bank loans. Prices reverse beginning in March, as peripheral yields begin rising again, then plummet in May as Greece's election raises the possibility of an imminent break-up. As the Greek crisis stabilises so do prices, which then commence rising again when Mario Draghi advances the offensive again. It's hard to see evidence of Fed draws in the chart, but Mr Draghi's "it will be enough" moment sticks out like a sore thumb.
Why should the euro crisis matter so much? The best guess is probably that no single other dynamic is responsible as much downside risk. If the euro area interdepends and returns to growth, America's markets will cease pricing in the possibility of disaster and lending conditions might ease considerably. China's exporters can exhale a sigh of relief. Global growth would apprehend a little, and the possibility of a substantial global contraction would shrink considerably. The euro crisis matters because it, more anything else, is setting expectations for the pace of global growth.
I was entertaining this relationship when reading through a short paper by a few economists at the Dallas Fed. Here's the abstract:
Resource utilization, or “slack”, is widely held to attic important determinant of inflation dynamics. As the world has become more globalized in recent decades, some have argued that the concept of slack that is relevant is global rather than domestic (the “global slack hypothesis”). This line of argument is consistent with standard New Keynesian theory. However, the empirical evidence is fragile, at best, possibly because of a disconnect between empirical and theory-consistent measures of output gaps.
Let's pause for a moment and think a little bit about inflation. If you look over at the latest consumer price index release from the Bureau of Labour Statistics, you'll see that the seasonally adjusted CPI jumped 0.6% from July to August. Dig into the details a little and you see that the price of most goods fell, the price of shelter rose a bit (which matters, because shelter is weighted very heavily in the index) and the price of energy soared. The energy index, which accounts for about 10% of the CPI, rose 5.6% from July to August.
That kind of rise is what you might call "cost-push inflation": prices rise because the cost of making various things goes up. That kind of inflation shows up in the consumer price index and impacts household budgets, but it's a "real" sort of inflation. Inflation from cost-push inflation aren't on their own enough to touch off runaway inflation. In response, households will either buy less of other things, creating downward price pressure, or buy less of the more expensive thing, or buy the same amount of the costlier thing once prices boil down thanks to rising supply. One way or another, the inflation impact of rising costs conks out.
Unless, naturally, workers anticipate that it will continue and are able to demand wage increases to compensate for it. If that's the case, an inflationary spiral may result; workers, observing price changes, invite hikes and firms, observing wage increases, raise prices. But workers can only demand and receive higher wages if the labour market is running close to full employment. Otherwise employers will just tell the easily replaceable complainers to take a hike. Another way of saying this is that sustained accelerations in inflation happen exclusively as a result of trying to sustain output at a level above potential. Steady acceleration in inflation is a demand-side issue (or, in Milton Friedman's phrase, it is always and everywhere a monetary phenomenon).
Therewith in mind, there are two ways in which global potential dismissed matters. The first is in the less derlying, monetarist way: inflation will rise and persist only if governments attempt to push output beyond the global economy's potential. In a globalised world, it's difficult for cost-push inflation to translate into a proper inflationary spiral because of the check cheap emerging-market labour provides on rich-world labour-market bargaining power. Rising goods prices can always be undercut via the rising industrial capacity of fast-growing emerging markets. And wages can only rise such in response to higher costs when the world economy is busy absorbing billions of new workers.
We can put this more simply. If there's more excess labour supply in the world, and global markets are relatively unfettered, then it's very difficult to imagine an inflationary spiral developing in an advanced economy. Unless, naturally, struggling workers in the advanced world react to the negative impacts of international competition by demanding protections.
Looking then at the period beginning in the early 1990s, when enormous amounts of new economic capacity began coming online in Asia, we see an extraordinarly lack of wage pressure in the advanced world. Unemployment in America was very low from about 1995 on and actually dropped to 3.9% in late 2000. Nominal average wage growth was around 5% per year from 1996 to 2000. That's high by recent standards but not compared to typical growth from about 1982 on (annual rates were much higher before the Volcker recessions) and there was no trend toward acceleration in the late 1990s. Inflation began rising in 2000, thanks mostly to an end to by period of flat to declining oil prices (though core consumer prices never rose much more 2% during this period). Since 2000, nominal average wage growth has nevermore reached 5%. Now perhaps this very mild wage growth is due exclusively to the credibility of central-bank policy—it was assumed that any acceleration in wage demands would quickly lead to a severe interest-rate response. But perhaps the bigger constraint was the enormous growth in the global labour force. Central bankers may have underestimated this potential and reacted more strongly than necessary to headline inflation driven by higher energy prices.
That leads us to the second way in which the global-potential dynamic could develop. We might instead find ourselves in a world in which central banks routinely treat cost-push inflation as real inflation. As I wrote back in February:
A central bank determined to contain inflation and which uses a measure of inflation heavily influenced by key resource prices will react to rising resource prices by tightening monetary policy to slow the economy. Now, standard central-bank practice is to take some of the impact of an oil shock in inflation and some in reduced growth. The point at which the central bank is likely to deputise and curtail growth is flexible. It's also likely to differ across countries and across development stages.I'm not quite sure what the optimal central-bank response ought to be...Perhaps, in the presence of substantial labour surpluses in advanced economies (and, maybe, globally) inflation is less worrying than in normal circumstances, as a lack of worker bargaining power constrains wage growth and inhibits accelerating inflation. Meanwhile, efforts to, essentially, hold down oil prices by constraining demand have the fallout of limiting exploration and innovation, which might ultimately ease the resource bottleneck.It's also possible that if central banks react to oil-induced inflation asymmetrically, then the outcome will simply be a shift in growth. Potential growth at a national level ceases to be relevant; global potential is the limiting factor. And to the extent that one economy slows itself to reduce its rate of inflation, others have more room to grow.The upshot of all this is: the primary economic threat from high oil prices may well be the reaction from central bankers. A slavish commitment to low and stable inflation might not be the optimal response to a world with a commodity-price speed limit.
In wrapping this up, however, it's worth noting that the commodity price constraint may be less of a durable feature of the world economy than many imagine. Countries are only beginning to appreciate, the rapid rise in oil prices over the past decade has triggered an extraordinary supply response. Efficiency gains have been substantial and both exploration and innovation in extraction have deducted.
In a fascinating post here, Michael Pettis explains that hard commodity prices as a whole might be in as by and steep decline. Accounts centres on China. In a very short period, China carried out a phase of very rapid economic growth, focused on the most resource-intensive aspects of catch-up. Soaring demand butted up against unprepared supply channels to generate spiking prices. Supply is responding to that price spike but on a lag. And so lots of new capacity is coming online now. But China's economy is now moving into a phase in which growth is likely to slow and the resource-intensity of growth is likely to slow. Resource-intensive growth may now shift to other emerging markets, but the world's fancy new resource-extraction capacity is unlikely to have to digest another huge lump of growth like the one experienced in the past decade any time soon.
If the resource-price moves that have been catching central bankers since 2000 suddenly moderate, then what happens next? If the global potential story is right, then the critical dynamic once again becomes the flow of new labour into the global economy. And perhaps i.e. set to slow, as well. There are still more than a billion potential workers lingering on the fringes of the global economy, of course, but they are scattered across many different countries and may not be able to flood onto the market as the rapid development of China and India allowed their masses to do. Maybe it won't be that long until American workers are able to regain a little lost bargaining power. That might make wage-price spirals more of a concern for central banks. But at last, that's not the worst concern to have to have.
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