Is the output gap smaller than we think?

January 6, 2010

Economist Kevin Kliesen at the St. Louis Fed asks that question in an article he published today.

In its 2009 Annual Report, the Bank for International Settlements discussed these “bubble-induced distortions” to current estimates of trend output growth and, hence, potential real GDP. Thus, it is conceivable that estimates of potential real GDP at the start of the recession were too large and that … structural adjustments … may have subsequently reduced potential real GDP from its artificially high level.While it is probably unlikely that the fall in actual real GDP during the recession has been matched by the fall in potential real GDP, the size of the output gap might be smaller than conventional wisdom might believe. If so, those who foresee little risk to the near-term inflation outlook because of a large, persistent output gap may be too optimistic.

Krugman Keynesians argue that the output gap restrains wage-push inflation and therefore the Fed and Treasury can stimulate without fear of sparking inflation so long as the unemployment rate is high.

But what is a high unemployment rate? Just as output was goosed by the credit bubble, so too was employment.

Kliesen argues that Bernanke has less room to maneuver than he thinks.


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Excellent find, Rolfe! This is affecting my viewpoint.

During the depression, prices did not fall nearly as much as one might think, because productive capacity plummeted as businesses went bankrupt.

We have had almost no deflation at all as supply has shrunk to match shrinking demand. What if demand merely rebounds? Stuff wears out! A lot of the housing ‘inventory’ is hardly inventory at all, decrepit foreclosures in bad neighborhoods, depressed cites and in pointless timeshare places. Unlike Japan, we are vigorously growing in numbers, necessitating future demand.

Meanwhile, debt-financed government spending will be putting a lot of money in peoples’ pockets.

Posted by Dan Hess | Report as abusive

I wish the Fed all the best in containing inflation. Even if there is a huge output gap, and even if wages actually fall rather than rise, input costs are going to go up (oil particularly) because the perceived value of the dollar will drop due to increased deficits and debt monetization (direct and indirect). Even if the people in the US can be bamboozled into believing the dollar is stable, foreign manufacturers and investors can’t be fooled.

Containing inflation is like containing a universal solvent. Not going to happen.

Posted by unirealist | Report as abusive

Interesting information, but I do not see any statistics to back it up. Maybe some backup will add far more credibility to the report. Would certainly hope that the author can follow up with a modeling of what he had said to further enforce his views.

Posted by Lim Boon Chuan | Report as abusive

To Dan,

“Meanwhile, debt-financed government spending will be putting a lot of money in peoples’ pockets.”

Unfortunately the government will fill the pockets of special interest groups first, since all our representatives seem to owe them their souls. Alas, even if we all got a huge shot of money inflation would render it futile.

Posted by al coholic | Report as abusive