Global Output Gaps & Inflation

The global economy looks a bit more ropey than it did a few weeks ago. Or at least is does if you’re taking your cues from equity and commodity markets, which have chosen to mark my return to the financial services industry with the worst start the year in decades.

I say “at least” because if you look away from the markets’ latest China-induced panic and towards real economic indicators things don’t look quite so bad.

The latest estimates from the usually reliable activity trackers at Fulcrum, as recounted by Gavyn Davies , put global growth at around 3.1%. Unspectacular by pre-crisis standards but in line with recent experience and indeed up from the 2.6% they were showing during the last bout of market turmoil in August/September 2015.

The broad global picture looks to be of reasonably ok-ish growth in developed economies coupled with weakness in the emerging world — although even in less developed countries, activity does seem to be stabilising. The most recent nose-dive in commodity prices should reinforce that trend, it is after all basically a transfer of spending power from commodity producers to commodity consumers.

Broadly put, the situation the US and UK find themselves in is as follows: growth is solid(ish) if unspectacular, labour markets are tightening and headline inflation is being kept low by falling commodity prices. All of that is understandable but what is perhaps more interesting is that core inflation rates (excluding energy and food) also remain weak.

It’s this last factor which has got me thinking about the role of global — as opposed to national — output gaps.

Last year Mark Carney presented some very interesting charts on global inflation dynamics and correlations.

Global inflation dynamics are becoming, well, more global. In other words inflation may be being determined less by national economic conditions and more by global ones.

Claudio Boro has been banging this particular drum for a decade now.

There has been mounting evidence that the inflation process has been changing. Inflation is now much lower and much more stable around the globe. And its sensitivity to measures of economic slack and increases in input costs appears to have declined. Probably the most widely supported explanation for this phenomenon is that monetary policy has been much more effective. There is no doubt in our mind that this explanation goes a long way towards explaining the better inflation performance we have observed. In this paper, however, we begin to explore a complementary, rather than alternative, explanation. We argue that prevailing models of inflation are too “country-centric”, in the sense that they fail to take sufficient account of the role of global factors in influencing the inflation process. The relevance of a more “globe-centric” approach is likely to have increased as the process of integration of the world economy has gathered momentum, a process commonly referred to as “globalisation”.

Or, to put in another way, low and stable inflation in the 1990s and 2000s was less to do with “better policy making”and more to do with the integration of the world economy. That’s, understandably, not a view that’s universally popular amongst monetary policymakers but is certainly one worth considering further: global output gaps may matter as much as than national ones.

Certainly at a time when the labour market is looking relatively tight in both the US and UK but whilst inflationary pressure remains weak, the idea that global spare capacity (rather than just low oil prices) is having an impact starts to sound plausible.

For what it’s worth, the Bank of England relatively firmly rejected the usefulness of a global output gap approach in 2008, as did the ECB.

Of course, as Carney’s charts make clear, the situation may have evolved since then. Certainly by 2012 the Fed’s James Bullard sounded much more keen on the concept.

A paper last year from Pym Manopimoke found that:

… a global output gap has replaced the domestic output gap as the key driving variable for inflation in 17 advanced and emerging countries, particularly since the year 2000. The crosscountry analysis also suggests that the influence of the global output gap for national price movements is positively correlated to a country’s degree of openness in trade… the global output gap remains a significant driving variable for inflation, suggesting that the global output gap matters for inflation beyond the traditional import price channel.

None of which is to say that excess spare capacity in China means the West is doomed to a deflationary spiral, national output gaps can still matter even in a world where the global gap plays a large role — tighter British and American labour markets are keeping a lid on deflationary pressure.

But it may suggest that whilst inflation is unlikely to turn out to be persistently negative it could remain tepid despite dwindling domestic spare capacity.

In the UK — more open to trade than the US and hence more exposed to the effect of a global output gap — the concept offers a gloomy take on the much debated productivity puzzle.

The strongest argument productivity optimists have had for the past few years has been: where’s the inflation?

The lack of a pick up in cost pressures (as measured by core rather than headline CPI) as been taken by many as proof that there is plenty of spare capacity left in the UK economy, suggesting the space of rapid rebound in growth. It may though be that it is global rather than national spare capacity which has held inflation in check.

But UK gloominess aside, this is surely a bigger issue for the Fed — whilst it may be the central bank of an economy that is less (in terms of trade) globalised, it’s also the central bank who’s decisions will have the most impact on the global output gap through the dollar’s international role.

Stanley Fischer is perhaps the most internationally minded senior Fed policymaker and this is what he had to say in late 2014 on the Fed’s responsibilities to the global economy.

These financial stability responsibilities do not stop at our borders, given the size and openness of our capital markets and the unique position of the U.S. dollar as the world’s leading currency for financial transactions…

But I should caution that the responsibility of the Fed is not unbounded. My teacher Charles Kindleberger argued that stability of the international financial system could best be supported by the leadership of a financial hegemon or a global central bank. But I should be clear that the U.S. Federal Reserve System is not that bank. Our mandate, like that of virtually all central banks, focuses on domestic objectives. (My emphasis).

He went on to argue that whilst the Fed was “mindful” of the role of the dollar overseas, “the most important contribution that U.S. policymakers can make to the health of the world economy is to keep our own house in order — and the same goes for all countries”.

But of course in a world in which the global output gap matters, simply keeping their own house in order isn’t really an option anymore.