WHAT IF THE OUTPUT GAP IS GLOBAL ? / THE WALL STREET JOURNAL

HANNON’S TAKE: WHAT IF THE OUTPUT GAP IS GLOBAL?

By Paul Hannon

Monday, July 27, 2015

CHIP SOMODEVILLA/GETTY IMAGES

Liftoff appears to be approaching, first for the Federal Reserve, followed by the Bank of England.

Both central banks are convinced the inflation rates they target are set to rise, and that a first tightening of policy in almost a decade is needed to prevent too rapid an increase in consumer prices over coming years.

Both interpret a recent pickup in wages as an indication the gap is closing between what the economy is producing and what it could produce if it operated at full capacity. And the narrower that gap, the stronger the upward pressure on prices. So now is the time to tap the brakes on what the economy is producing.

The officials who will decide when to raise interest rates have a lot of information at their disposal, and they have a great deal of experience analyzing developments in the U.S. and U.K. economies, respectively.

But after three decades of breakneck globalization, inflation may no longer be a national phenomenon, even if the national economy in question is very large. That possibility was acknowledged as far back as 2006, in a paper co-authored by Claudio Borio, who is currently head of the Monetary and Economic Department at the Bank for International Settlements. Federal Reserve Bank of St. Louis President James Bullard considered the evidence in 2012 and concluded that “there are good reasons to think that…the global output gap is a relevant indicator for domestic inflation.”

Back then, Mr. Bullard was trying to explain why inflation rates were moving higher than seemed justified by the U.S. output gap alone. Back then, emerging markets economies were running hot.

Now, of course, many aren’t. China’s State Council Friday promised more policies to bolster its embattled trade sector as a gauge of manufacturing activity showed new sluggishness in the economy. Other large developing economies aren’t doing much better, the main exception being India.

So it’s quite likely that the hard-to-measure global output gap is pretty wide, and that is reflected in falling commodity prices and inflation rates that are very subdued in most major economies.

If it is the global output gap that matters, both the Federal Reserve and the Bank of England may have little to fear from inflation should they decide to hold off raising rates until 2016, or even later. They may want to go earlier for other reasons–for example, a concern that risks to financial stability are mounting–but that is a different argument.