Inflation

It always ends up at the same place. Any discussion of inflation -- what it is, what causes it -- comes back to that never-ending debate between money and the output gap.

First, some background. The late Nobel laureate Milton Friedman is remembered for many things, among them his oft- quoted observation that inflation is “always and everywhere a monetary phenomenon.”

If the central bank creates more money than the public wants to hold, the public will spend it, bidding up the prices of goods and services. When too much money chases too few goods and services, the result is a rise in the price level, or inflation.

It’s easy to lose sight of Friedman’s axiom nowadays. Central bankers often talk about higher oil prices and rising wages as if these price increases cause inflation rather than reflect it.

The other theory of inflation, popular among Keynesian economists and Phillips Curve advocates, is something called the output gap, or the difference between the economy’s actual and potential output.

The economy’s potential growth rate is circumscribed by the growth in the labor force and in productivity. These are estimates that have turned out to be overly optimistic (in the 1970s) or too pessimistic (in the 1990s). In both cases, the perceived “gap” failed to predict inflation, or its direction, correctly.

Mind the Gap

Actual output, or real gross domestic product, is also an estimate -- even after it’s reported. Real GDP growth gets revised, re-revised and revisited ‘til the cows come home.

When actual GDP consistently exceeds potential GDP -- the gap is gone -- inflation accelerates, according to the theory. On the other hand, when potential is greater than actual -- when, for example, the unemployment rate is high and industries are operating well below capacity -- the gap provides a buffer against inflationary pressures.

There is something superficially appealing about the output gap model. After all, if the demand for goods and services exceeds the economy’s ability to produce them, businesses raise prices to allocate scarce resources. Put another way, if you can’t produce more stuff, you get higher prices.

Faulty Reasoning

So what’s the matter with that logic?

For starters, aggregate measures -- aggregate demand, aggregate supply -- and inflation are macroeconomic concepts. Prices are set at the firm, or micro level. High unemployment among auto workers has nothing to do with the price of beans, even though expectations about aggregate prices are a consideration for businesses, according to Marvin Goodfriend, professor of economics at Carnegie Mellon’s Tepper School of Business in Pittsburgh.

There’s a bigger problem with the output gap theory. It’s “unsupported by statistics and history,” says Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago.

Kasriel tested the correlation between the output gap and the core personal consumption expenditures price index, a measure touted by former Federal Reserve Chairman Alan Greenspan that made inflation look as low as possible.

He found that the correlation coefficient was 0.45 out of a possible one. “Not bad,” he says, “except the sign in front of it was a minus.”

In other words, the gap and inflation are negatively correlated.

Empirically Challenged

Kasriel did manage to produce a positive correlation of 0.45 when the gap leads inflation by 12 years. That’s well beyond Fed Chief Ben Bernanke’s expanded three-year forecast horizon. (The positive correlation between the output gap and M2, the broad monetary aggregate, rose to 0.68 with money leading inflation by three years, he says.)

The final problem with the output gap theory is history. One can point to “lots of examples of countries with underutilized resources and high inflation,” says Allan Meltzer, a professor of political economy at Carnegie Mellon. “Brazil in the 1970s and 1980s.”

Inflation in the U.S. staged a comeback in the mid 1930s, even with the unemployment rate in excess of 20 percent. The 1970s witnessed a hardly peaceful coexistence between high unemployment and high inflation.

Estimating the output gap is a vital ingredient in many official forecasts. For example, in its March budget and economic outlook, the Congressional Budget Office said real GDP will average about 7 percent below potential for the next two years.

Either Or

“Because of the likely persistence of the various factors holding down economic activity, CBO does not expect the output gap --- the difference between actual and potential output of goods and services --- to close fully until about 2014,” according to CBO.

That means the output gap gives the Fed a lot of breathing room to address the financial crisis without worrying about inflation. Or else it’s a squishy construct to hang your hat on if you’re Ben Bernanke looking at a $2 trillion federal deficit, a $2.2 trillion balance sheet and $804 billion of excess reserves.