Investors ask a lot of questions. Why has job growth been so weak? Is Candy Crush really a steal at 15 per cent below the initial public offering price, even if there is no way the company can make money? Did the Fed chair make a rookie mistake the other week, or did she just put investors on notice of a rate hike next spring? It's investors' questions, and the answers that follow, that drive asset prices.
Another key question on many investors' minds is why inflation has suddenly slowed globally. The inflation trends in the United States have certainly been no exception. The core consumer price index (CPI) is down 0.4 of a percentage point in the past year, resting at a two-and-a-half-year low of 1.6 per cent year-on-year. The core personal consumption expenditure (PCE) deflator is at 1.1 per cent.
Whether investors get the answer right depends on asking the right questions in the first place. In the case of inflation, investors may well be asking exactly the opposite question that they should be asking.
The real inflation question is, why has inflation stayed so high in the aftermath of the greatest recession since the Great Depression of the 1930s?
Other large recessions brought about much larger inflation declines. In the 1930s, alongside a 20-per-cent unemployment rate, total consumer prices (there was no core CPI back then) contracted by 25 per cent and did not return to their 1929 peak until 1943. In the early-1980s recession, unemployment shot up to almost 11 per cent and core CPI growth dropped from 11.8 per cent to 3.6 per cent in just three years. Even the barely-there recession of 2001 slowed inflation by more than one percentage point.
Why then, in the aftermath of the Great Recession, which generated a 10 per cent unemployment rate, has U.S. core inflation only slowed to just below the Fed's long-term target of 2 per cent for PCE (about 2.5 per cent for CPI), more than five years after the greatest financial crisis since the roaring 1920s?
Many analysts, including those at the Federal Reserve, point to the prompt and aggressive monetary policy reaction to the 2008 credit crisis, which kept inflation expectations on an even keel and very close to the policy target. While this is true, it does not alone explain why inflation remained so buoyant. After all, inflation expectations did not budge during the 2001 recession. And in the early 1980s, the collapse in actual inflation preceded the drop in inflation expectations by more than a year.
If inflation expectations are not the answer, then investors need to be looking at the other part of the inflation model for the answer: Just how big is the output gap, really?
There are lots of ways to measure spare capacity. Most have technical and important-sounding names such as band-pass filters, long-run restriction models and multivariate Hodrick-Prescott filters. The Congressional Budget Office (CBO) uses one such model to derive potential output. The Fed, which does not publish its own measure, often endorses the CBO's. By this measure, the output gap reached 7.4 per cent of actual gross domestic product in early 2009 and the economy still has 4-per-cent spare capacity, consistent with the "ample spare capacity" meme in the market.
Since the recession of the 1980s generated a similarly large output gap of 8 per cent by 1982, why did inflation collapse by more than 10 percentage points back then, but by a mere fraction of that since the Great Recession?
The answer may be that there is not nearly as much spare capacity in the U.S. economy as the conventional measures used by the Fed and the CBO suggest.
Although these potential output models sound sophisticated, when you break them down, they are in essence long-run averages of the determinants of potential GDP output: total factor productivity, labour force and the capital stock.
By the CBO's measure, businesses take an eternity – about 12 to 15 years – to adjust to changes in the economic landscape. But do they really take that long? It is certainly not consistent with what is observed in the economic data. For example, capacity utilization collapsed to 66.9 per cent in 2008, but is currently just a touch below the long-run trend at 78.8 per cent. Same goes for other capacity metrics, such as the supplier deliveries component in the Institute for Supply Management (ISM) manufacturing and non-manufacturing surveys.
For those who do not trust any economic data, just ask yourself: When was the last time you flew on an empty airplane or sat in an empty movie theatre? (Hot Docs don't count, because no one ever goes to them.)
Using a potential output measure with shorter average growth rates (five years) of the components of potential, you get much slower potential GDP growth of 1.5 per cent currently. This output gap matches the trends in the other capacity metrics much more closely than the CBO measure and, more importantly, suggests spare capacity is under 1 per cent currently, rather than the 4 per cent cited by the CBO and the Fed.
If the truth about spare capacity is closer to the former than the latter, there are important monetary policy and market implications.
First is that inflation may accelerate, and sooner rather than later. The second is that the Fed may respond by raising rates sooner than expected, although it is likely to be less aggressive than inflation trends dictate, given very dovish new Fed chair Janet Yellen. The third is that the yield curve in the bond market may not bear-flatten (front-end yields rising by more than the back end) as severely as in prior rate-hike cycles, due to the aforementioned dovish chair. So watch those forward rates, and inflation-protected securities (TIPS) are definitely a buy.
Sheryl King is an independent macroeconomic strategist with more than 20 years experience in the international financial industry and central banking.