Paul Krugman has been a major proponent of the idea that since the economy is facing a so-called output gap, then we needn’t worry about inflation. Basically, since we have so many idle workers and factories, there’s really no chance we could overheat, face supply constraints, and thus cause prices to spike. So, we might as well keep printing.
Reuters’ Rolfe Winkler points to a precentation given by the Fed’s James Bullard that’s clearly a direct rebuttal to Krugman. The argument is pretty simple and intuitive: When you’re coming off of a bubble, the previous full potential of the economy is nothing that could be considered sustainable or re-achievable.
“I am concerned about a popular narrative in use today—the narrative being that the output gap must be large since the recession is so severe,” he said. “And so, any medium-term inflation threat is negligible, even in the face of extraordinarily accommodative monetary policy. I think this narrative overplays the output gap story.”
He added that measuring the gap is very difficult, both theoretically and practically. He cited research that shows much of the inflationary run-up in the 1970s can be attributed to a misreading of the output gap at the time.
“Even if economists were to accept a particular measure, the empirical relationship with inflation is not robust,” he said. In addition, traditional output gap measures do not account for the concept of bubbles.
“It has been popular to describe recent events as a collapse of a bubble in housing. A look at the housing data makes a convincing case,” Bullard said. “But when it comes to calculating traditional output gaps, there is no notion of a bubble. If part or most of the fall in output was a collapsed bubble, then today’s output gap would be smaller than it appears.” This would mean that inflation risks in the medium term are higher than otherwise thought.
Here’s the full deck of Bullard’s presentation at the National Association for Business Economics. The section on the output gap is the third part.