Note on U.S. Inflation

April 20, 2009

One of the conceptual tools that economists use to analyze inflation is the output gap, which compares the long-run trend of economic growth, also known as potential GDP growth, to the actual trend in output.  When potential lies below actual, inflation tends to accelerate, but when actual as now is below potential, the opposite occurs.  The transformation of excessive liquidity into rising inflation doesn’t occur until actual output exceeds potential GDP.  Otherwise, the economy is operating with under- and unutilized resources and is able to expand faster than its potential rate as labor and capital resources get reabsorbed without generating higher inflation.

The U.S. growth speed limit limit lies somewhat above 3.0%.  Real GDP advanced 3.4% per annum in the 25 years to 2Q00 and 3.6% per annum in the previous twenty-five years.  From 2Q00 to 1Q01, however, GDP increased only half as fast as potential GDP because of two recessions and a sub-trend period of expansion.  A large output gap developed, and it would take growth of 6.2% per annum to steepen the slope of the actual growth vector sufficiently to intersect the potential growth vector within the space of five years, that is by sometime within the first half of 2014.  Not in most people’s memory has U.S. GDP expanded that rapidly for five consecutive.  The point is that considerable lead time safely exists for fiscal and monetary policymakers to shift their orientation from countering recession to forestalling inflation. The impression that this year we have recession, but runaway inflation will be a problem in 2010 or even 2011 seems highly implausible.  And the only way I see such a compressed swing from one extreme to the other involves a total collapse of the dollar that sends import prices and long-term interest rates skyward.

Copyright 2009 Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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