‘Output Gap’ Indicates There Won’t be any Inflation

What’s an ‘Output gap’?

Well, it’s the latest phrase being used by ‘Born-again Keynesians’ to argue there won’t be any inflation.

We say ‘latest,’ but the idea has been around for years. It’s just that now is the time that mainstream economists need to use it to back up their anti-inflationary case.

Your editor was kindly supplied with the following chart over the weekend by a Money Morning reader…

Evidently it is from an email sent out by Macquarie Group interest rate strategist Rory Robertson. According to Robertson, because the green line is so far below the zero line, inflation won’t be a problem until it rises above the green line.

The argument seems to be that because there is so much ‘slack’ in the economy, price pressures will be downward rather than up.

Or, to put it another way, supply exceeds demand, so prices must surely fall.

But rather than rely on your editor for a real definition of the ‘output gap’, why don’t we hand it over to the ‘experts.’ In this case, the Reserve Bank of New Zealand (RBNZ):

“The output gap is the difference between demand and supply and the economy’s capacity to supply. This is the difference between the ‘actual’ level of output (GDP) and the economy’s ‘potential’ level of output (potential GDP).”

Got that? Sounds simple enough. But there’s nothing like a diagram to hit it home, so here goes, plus a bit more detail from the RBNZ:

“If the economy is running above capacity (GDP > potential GDP) the output gap is positive. Conversely, if the economy is running below its full capacity (GDP < potential GDP) the output gap will be negative.”

We’ll be honest. We don’t get it. Or rather, we do get it, but we don’t quite see how this backs up the theory that inflation isn’t an issue.

According to the argument of Robertson and others, until the red line in the diagram above crosses back over the blue line so there is a positive output gap, then inflation is of no concern whatsoever.

Or as Robertson argued in a note to clients last week:

“To me, the idea that controlled and modest “money printing” designed to stop the financial sector from imploding will somehow – magically – turn the economic problem from potential deflation to excess inflation seems ridiculous. Get a grip – it’s not happening.”

Ah, so “modest” money printing is fine. Which means immodest money printing is not fine? Could that be because expanding the money supply is inflation? So therefore printing money does cause rising prices.

Hmmm. We think Robertson needs to get his story straight. Is ‘money printing’ good or bad?

As we see it – and as per usual, we’re happy to be proved wrong – there are at least a couple of problems with the ‘output gap’ theory.

The obvious one is that it relies on – dare we say it – unreliable data, namely GDP figures. Look at the fuss caused in recent months over whether Australia is in a recession, a technical recession, recessionly technical or just… fine because Australia is different.

Secondly, we’re trying to grasp the concept of “Actual GDP” and “Potential GDP.” Isn’t GDP supposed to be the economic output of an economy? If that’s the case then it is what it is. You can’t have potential GDP and actual GDP. It’s just GDP.

Potentially, your editor could become a full forward for Collingwood. But due to our complete inability to kick an Australian Rules football we’ve got little chance of achieving this.

But using the output gap theory, my ‘potential’ as an AFL footballer would be valid if we compared our actual output (writing newsletters) to our potential output (kicking footballs).

What counts as potential? Are there degrees of potential?

It just doesn’t make sense – and maybe our football analogy doesn’t either, but hopefully you get the point!

The other problem with the ‘output gap’ theory is the idea that because the economy is operating below capacity then it’s impossible for prices to rise.

Again, this is incorrect. And it’s wrong on two counts. First, while it is true that oversupply will always lead to a falling price, it is not the case if supply falls in line with demand.

The argument put forward by the anti-inflationists seems to believe that business will continue to produce excess supplies which will force prices down. If businesses do so then they are heading for trouble. We would hope that any business worth its salt would see that demand has slipped and will therefore pare back production.

This will lead to a price equilibrium of supply and demand, and prices will stabilize, and potentially if businesses cut back too far.

But there’s a further complication…

You see, after experiencing a boom, it is logical that there should be a bust. Only the “controlled and modest” money printing, government bail-outs and cash bribes is trying to prevent that.

So, it is possible that due to government stimulus packages, prices will not fall as consumer demand slips, and that businesses will continue to produce either to benefit from government spending or because they are seeing false signs of a recovering economy – because of the government spending.

So, instead of prices falling to take into account a lower level of demand, prices are being propped up – especially in the housing market, but elsewhere too.

And this is where things really will start to bite. The artificial prevention of falling prices is harmful to consumers. It is making the consumer pay more for items. More than they would if prices had fallen following the end of the boom.

Now, if you’re in gainful employment then you may not see much difference. In fact, if you’re in gainful employment and you’ve got a mortgage then you could even be better off thanks to the interest rate cuts.

But what about those that have lost their job? At the moment the unemployment rate is less than 6%. Some forecasts have that reaching 9% by the end of next year. Maybe it will be somewhere in between. Maybe it will be higher. Who knows.

What we do know is that anyone who works at least one hour per week is classed as being employed. And further, if business does react to slowing demand and cut production, rising prices is inevitable as those that do have spending capacity – including government, continue to spend.

The result is a new level of demand pushing prices higher.

We’ll have more on this later in the week. In the meantime, look out for those Born-again Keynesians!

Other Stuff on the Markets

The S&P/ASX200 gained 1.24% on Friday, while on Wall Street with the Dow Jones Industrial Average dropped 34 points. In Europe the FTSE100 fell 0.27%, while the CAC40 slipped 1%.

The price of gold in Australian dollars is trading at $1,162.50, while in US Dollars it trading at $937.02.

The Aussie dollar remained steady versus the US dollar and Japanese Yen, trading at USD$0.8062, and JPY76.86.

Crude oil closed at USD$69.04.

For the biggest movers on the market yesterday click here…

Kris Sayce
Kris is never one to pull punches when discussing market developments and economic events that can affect your wealth. He’ll take anyone to task — banks, governments, big business — if he thinks they’re trying to pull a fast one with your money. Kris is also the editor of Microcap Trader — where he reveals the best opportunities he’s discovered in the markets. If you’d like to more about Kris’ financial world view and investing philosophy then join him on Google+. It's where he shares investment insight, commentary and ideas that he can't always fit into his regular Money Morning essays.

Kris Sayce is the Publisher and Investment Director of Australia’s biggest circulation daily financial email, Money Morning Australia.Kris is a fully accredited advisor in shares, options, warrants and foreign-exchange investments.

Kris has close to twenty years’ experience in analysing stocks. He began his career in the biggest wasp’s nest in the financial world — the city of London — as a finance broker back in 1995.

It’s there where he got his ‘baptism of fire’ into the financial markets, specialising in small-cap stock analysis on London’s Alternative Investment Market. This covered everything from Kazakhstani gold miners to toy train companies.After moving to Australia, Kris spent several years at a leading Australian wealth-management company. However he began to realise the finance and brokerage industry was more interested in lining its own pockets with fat fees, commissions and perks —rather than genuinely helping out the private investors they were supposed to be ‘working’ for.

So in 2005 Kris started writing for Port Phillip Publishing — a company which was more attuned to his investment outlook.

Initially he began writing for the Daily Reckoning Australia— but eventually, took over Money Morning. It’s now read by over 55,000 subscribers each day.

Kris will take anyone to task — banks, governments, big business — if he thinks they’re trying to pull a fast one with your money! Whether you agree with him or not, you’ll find his common-sense, thought-provoking arguments well worth a read.

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7 Comments on "‘Output Gap’ Indicates There Won’t be any Inflation"

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Chris, I can just about see how in an enclosed system (no exports, no imports) GDP could be less than a countries ‘potential GDP’ (whatever that is) but utterly fail to grasp how GDP can be greater than PGTP. It is true that in the short term manufacturers can temporarily overproduce (>PTGP) and be forced to sell goods at a lower price but this would surely produce deflation and in very short order bankruptcy for the producer. It is unfortunately all too obvious that the American building industry produced surplus housing along with inflation in that particular marketplace but that… Read more »

ref previous email please read PGTP and PTGP as PGDP – Potential GDP.

Senior moments coming up faster than expected

Inventory and demand are being ignored by both sides of the argument here. Juxtaposing retail sales having kept up better than expected and sharply lower merchandise import figures tells you what? A: Firesale prices of excessive inventories or goods in transit. This effect is enflamed by the withdrawal or sharply increased cost of inventory finance as banks and govt desperately seeks to protect just two classes of asset & underlying industry being real estate and financial services. The merchandise economy is yet to be remeasured at the cash register in volume terms with cash accounting prices after the reduced supply… Read more »
Kris, First off, don’t get me wrong, I’m with you all the way that this Potential GDP guff sounds like utter rubbish. I’ve seen first hand the inflationary effects that drastically cutting production and productivity can have … you see, quite often it is very hard to turn it back on like a switch (especially if you have retrenched a number of skilled people from say the mining industry and they have now moved out of town and drive taxis or bag groceries). However, I do disagree with your argument about inflation in Zimbabwe. Yes, their past GDP has been… Read more »

Your doing a great job


This is my first time that I have been able to browse around and have found it very enjoyable Kind regards Stan


There is a feeling of “Iknew it!” as all my gut feelings and home made suspicions and theories are eloquently? and decisively bounced back at me through the writings of the Daily Reckoning and Money Morning writers. Sooo good to read some straight talk, that makes sense! . . .