What does anybody have to say about one of the mainstream’s favorite inflation predictor? The Output Gap is what’s resorted to in order to gauge the level of future inflation from current economic activity.
I am shooting from the hip on this one, but first some background:
The Output Gap is the percent difference between actual GDP and some “potential” GDP or ((Actual GDP - Potential GDP)/Potential GDP). The theory (based on that of market equilibriums) goes that an output gap is the result of an inefficient use of resources (ie: positive = too much output, negative = too little output) versus a theoretically market-clearing equilibrium. It is supposed to essentially be a measure of overconsumption or underconsumption, with demand driving the direction of price changes.
Now as Austrians are undoubtedly aware, GDP is, at it’s heart, a monetary statistic. It is very susceptible to fluctuations in the monetary base as well as credit expansion as it is essentially a sum of total expenditures vs. total revenues for a country. The value of the knowledge gleaned from this statistic may be dubious at best but there is no question that it does reflect at least to some extent that level of activity in an economy. So is it of actual use when trying to (roughly) gauge inflation risks?
At first blush I’m tempted to dismiss the Output Gap as utterly useless when predicting inflation since Potential GDP is all but worthless in the real world, but it seems to me that there is some real information to be gleaned from the Output Gap. It does, after all, reflect changes in money supply and credit, the two things that do actually cause inflation.
Assume the economists can make a reasonably good ballpark of potential GDP (yes, yes I know some of you will say that’s throwing them a pretty big bone but for the sake of argument let’s assume these guys can get it reasonably close. Goldman seems to have a decent handle on predicting GDP after all, but that’s probably because financials have become a massively huge contributor to GDP. So they’d better be good at it…) Anyway, ideally it seems to me like the economists would like to see the actual GDP curve have a slope that is similar to the slope of the predicted GDP (which is likely an extrapolation of a line of best-fit based on historical data.) What this means is that, because inflation is already discounted in the GDP statistic, the Output Gap cannot predict the inflation rate but it may give a hint to accelerating inflation, or deflation as the case may be. Since actual GDP and potential GDP must have a common, historical starting point, or origin, we must conclude that any deviations by actual GDP from potential GDP must result in a change of slope. Slope is the rate of change in “growth” which also reflects the effects of inflation.
'Course you still gotta sort inflation from actual growth but given an Austrian analysis could one not make a reasonable guess as to where the growth is coming from? Like now; no broadly significant technological changes affecting production efficiency, just expanding credit and larger scale. (I view globalization as a “bigger hammer” way of increasing output.)
What say you? I insist everybody who can, criticize.