Mind the Output Gap?


My man Larry Kudlow — with whom I frequently disagree, but always like and respect — penned a mighty piece for the WSJ today.

Here’s the money paras:

“Up to now the Fed has ignored forward-looking commodity and financial price signals in favor of an “output gap” model of inflation that argues against broad price increases so long as underutilized resources and idle capacity exist in the economy. This output gap approach is reminiscent of the “cost push” arguments of the inflationary 1970s, whereby wages, not money, were fingered as the principal inflation culprit. The Fed’s output-gap argument also looks a lot like the old Phillips Curve trade-off between falling unemployment and rising inflation dressed up in new scientific garb. But that too failed dismally as a policy guide during the ’70s.

Why monetary decision-makers fight the overwhelming historical evidence that inflation is always a monetary problem is hard to fathom, yet they do. No one has waged this fight more energetically than Fed Gov. Ben Bernanke, who in speech after speech argues that rising bond rates and a pronounced dollar decline relative to gold, commodities and foreign currencies doesn’t really matter. Ironically, the output gap he keeps trying to sell to a skeptical financial market audience is really a fiscal indicator, not a monetary one. (emphasis mine)

I couldn’t agree more with the Milton Friedman half of this argument: Monetarism, IMHO, has proven itself. I see it all the time in how M2 impacts the stock markets.

But LK shifts into a bit of econoblather:

Actual economic growth trends above or below a hypothetical level of full-employment GDP are the single biggest factor in budget swings between surplus and deficit. As economic resources have been underemployed for some time, the budgetary consequences have been severe.

Chairman Greenspan has suggested that full employment would today equate to a 4% unemployment rate. The current rate is 5.7%. That “unemployment gap” of 1.7 percentage points represents underutilized labor resources. It’s a shorthand version of the overall GDP output-gap problem, which also includes underemployed business assets.

I don’t buy it. That’s the classic Supply Side “We can grow our way out of the deficits” argument. It is simply unproven, and not persuasive. Indeed, one coul;d argue the Reagan and Clinton tax increases demonstrated has outright disproven that thesis.

But where Kudlow really nails it is his explaination of forward-looking inflation-sensitive indicators:

“Economic history and analysis show that forward-looking inflation-sensitive indicators such as bond rates, gold and commodity prices, and the exchange value of the dollar best reflect the inflationary risk of excess money. These indicators have recently been warning of higher inflation despite the fact that the economy is still underemployed.

Over the past three months the basic inflation rate (excluding food and energy) has moved up near 3% at an annual rate, about 1 percentage point above the Fed’s 2% target. Overall inflation in the first quarter increased 5.1%. Producer price inflation is also moving up.”

He’s right, and here’s the proof:

Commodity Prices
Source: Barron’s

Good stuff.

Mind the Output Gap?
April 21, 2004; Page A18

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