In congressional testimony Wednesday, Alan Greenspan signaled the public that small interest-rate increases will occur sooner than expected as a result of strong economic growth.
As a nod to strong price trends in gold and commodities, as well as rising bond yields — all traditional harbingers of excess liquidity and mounting inflation — many investors would like to see a bit less money created by the central bank. I believe that a few small restraining steps now will save the Fed, the stock market, and the economy a lot of high-interest-rate angst down the road.
Up to now the Fed has ignored forward-looking commodity- and financial-price signals in favor of an “output gap” model of inflation, which argues against broad price increases so long as under-utilized resources and idle capacity exist in the economy. This output-gap approach is reminiscent of the “cost-push” arguments of the inflationary 1970s, whereby wages, not money, were fingered as the principal inflation culprit. The Fed’s output-gap argument, while dressed in new scientific garb, also looks a lot like the old Phillips-curve tradeoff between falling unemployment and rising inflation. That also failed dismally as a policy guide during the ’70s.
Why monetary decision-makers fight the overwhelming historical evidence that inflation is always a monetary problem is hard to fathom, yet they do. No one has waged this fight more energetically than Fed governor Ben Bernanke, who in speech after speech argues that rising bond rates and a pronounced dollar decline relative to gold, commodities, and foreign currencies doesn’t really matter. Ironically, the output gap he keeps trying to sell to a skeptical financial-market audience is really a fiscal indicator, not a monetary one.
The term output gap simply means that the actual level of today’s inflation-adjusted gross domestic product is below a theoretical level of GDP that would have been achieved if the economy were growing at its fullest potential. In this, the former Princeton economics professor is surely right about the gap. Since the onset of the 2001 recession, the economy has fallen behind its long-run potential by $4.4 trillion.
This calculation assumes trend growth in GDP of 3.5 percent per year, which is the historical record of the U.S. economy since 1947. For last year’s fourth quarter alone, potential GDP was about $11 trillion, while actual GDP came in at $10.6 trillion. In this case, the difference — or output gap — is roughly $400 billion.
Actual economic growth trends above or below a hypothetical level of full-employment GDP are the single biggest factor in budget swings between surplus and deficit. As economic resources have been underemployed for some time, the budgetary consequences have been severe.
Fed chairman Alan Greenspan has suggested that full employment would today equate to a 4 percent unemployment rate. The current rate is 5.7 percent. That “unemployment gap” of 1.6 percentage points represents underutilized labor resources. It’s a shorthand version of the overall GDP output-gap problem, which also includes underemployed business assets.
So, by producing and employing below the long-run potential of the American economy, a sizable shortfall of income and wealth has occurred. Consequently, tax receipts from wages and salaries, corporate profits, and capital gains have also fallen well short. This, above all else, has worsened the budget picture.
Assuming an average tax rate of 20 percent — the rule-of-thumb used by most green eyeshades in government — personal- and business-tax revenues in the last quarter fell about $80 billion short of potential. That’s $320 billion at an annual rate and about two-thirds of the $480 billion budget deficit estimated by the Congressional Budget Office.
It’s clear then that the underemployment of the economy and the wide output gap between actual and potential GDP are the major deficit-causing factors in today’s fiscal picture. However, economic growth has quickened significantly since President Bush’s across-the-board tax cut was implemented retroactively last year.
And herein lies the solution.
If these new tax incentives are permanently left in place, as the president proposes, then the gap between actual and potential U.S. economic growth will narrow rapidly. As a result, so will the budget deficit. Installing tax incentives to generate a more rapid return to full employment throughout the economy is the most vital deficit-reducing action the government can take.
Importantly, a full-employment American economy, with 3½ percent long-term growth and 4 percent unemployment in the years ahead, will produce a new cycle of budget surpluses beginning in 2011. As the economic baseline used by the Congressional Budget Office falls well below full employment — the CBO figures only 2.8 percent yearly growth and 5 percent unemployment — today’s long-range budget outlook appears much worse than is actually the case.
Ben Bernanke has helped make this picture clear. Where the Fed governor errs, however, is in linking the underemployed economy and the continued absence of inflation. Between 1965 and 1981, U.S. policymakers learned painfully that virulent inflation is quite capable during periods of rising unemployment and slowing economic growth. That’s because inflation is a monetary problem. At any given level of output, or output gap, the Federal Reserve can still supply more money than the economy requires. It is this excess money that drives up prices and drives down consumer purchasing power.
Economic history and analysis show that forward-looking inflation-sensitive indicators such as bond rates, gold and commodity prices, and the exchange value of the dollar best reflect the inflationary risk of excess money. These indicators have recently been warning of higher inflation despite the fact that the economy is still under-employed.
Over the past three months the basic inflation rate (excluding food and energy) has moved up near 3 percent at an annual rate, about 1 percentage point above the Fed’s 2 percent target. Overall inflation in the first quarter increased 5.1 percent. Producer price inflation is also moving up.
In all likelihood U.S. economic efficiency would be maximized with a consumer price trend of roughly 2 percent per year. Not too hot, not too cold. Permitting inflation to rise beyond that, however, would threaten the national goals of price stability, full employment, and fiscal balance.
Governor Bernanke’s output gap is surely a budgetary problem. But it’s not an inflation solution. To maintain price stability the central bank must normalize its target rate and remove excess money from circulation. The sooner they act, the less action it will take.
— Larry Kudlow, NRO’s Economics Editor, is CEO of Kudlow & Co. and host with Jim Cramer of CNBC’s Kudlow & Cramer.