Potential Income and Inflation--Some Alternative Scenarios

During the Great Moderation, money expenditures remained very close to a 5 percent growth path. During the Great Recession, money expenditures, as measured by Final Sales of Domestic product, have fallen approximately 13 percent below that trend growth path. The price level, as measured by the GDP implicit price deflator, is approximately 2 percent below its growth path. Real expenditures and real GDP are about 11 percent below their growth path.

If the productive capacity of the economy has continued on its growth path from the Great Moderation, then real output is far below that growth path. If the Fed had increased the quantity of money enough--undertaken sufficient quantitative easing--then real expenditures and real output should have remained near that growth path. The price level should have remained very close to its 2 percent growth path of the Great Moderation.

The CBO estimates that the productive capacity of the economy has grown slowly for the last several years. The estimated growth rate for the third quarter of 2010 was only 1.5 percent, about half of the long term trend. If money expenditures had continued to grow with the 5 percent growth path of the Great Moderation, the price level would have risen and so, the inflation rate would have been substantially higher.

Some of the critics of quantitative easing complain that it will be inflationary. There are many possible reasons for this view--most of which involve the assumption that the Fed will not be willing or able to sell off the assets it has accumulated and reduce base money when needed. Another possible concern, however, would be that the CBO has failed to properly estimate the decrease in the productive capacity of the economy. Perhaps all of the decrease in real output reflects a decrease in productivity.

The principle of market clearing suggests that if the productive capacity of the economy has fallen by anything less than 11 percent, there would be surpluses of goods and services and an incentive for firms to lower their prices. That would increase real expenditures and real output, bringing it back up to the productive capacity of the economy. The implication, then, is that because the price level is only 2 percent below its trend of the Great Moderation, the productive capacity of the economy has fallen approximately 11 percent below its trend.

If money expenditures had remained on the growth path of the Great Moderation, and the productive capacity of the economy had fallen approximately 11 percent below its growth path of the Great Moderation, then the result would have been a very significant increase in the the price level. The inflation rate would have been much higher.

In the following diagram, the trend growth rate of real GDP from the Great Moderation is shown in black. It has a 3 percent growth rate and is also the trend growth path of the CBO estimate of productive capacity during the Great Moderation. The green line shows the CBO estimate of potential income, and it began growing more slowly in 2006. It is now 3.8 percent below the trend of the Great Moderation. The blue line (which is difficult to see,) is real GDP. The red line is an estimate of potential income based upon "market clearing" principles. It is simply the same as real GDP during the Great Moderation and the Great Recession. On this view, the Great Recession was a very large downward shift in the growth path of potential income, and the trend then continues based upon the average rate since the recovery began, which is almost exactly 3 percent.

The focus on growth paths is a bit unconventional. It is much more common to just look at the growth rates. The growth rates are shown in the following diagram. The black line shows the 3 percent trend growth rate for the Great Moderation. The green line shows the growth rate of the CBO estimate of potential income. Notice that it is now approximately 1.5 percent, very low compared to the long term trend. The blue line is the growth rate of real GDP. The red line is the market clearing growth rate of potential income. It follows real GDP growth, but it estimated trend from during the recovery is almost exactly back on the long term trend growth rate of the Great Moderation.

What about the price level. Suppose money expenditures--Final Sales of Domestic Product--had remained on its growth path of the Great Moderation. (In my view, that would have required quantitative easing in 2008 and 2009.) The equilibrium price level would depend on potential income. The red line represents the price level consistent with the assumption that the entire decrease in real GDP was due to a decrease in potential income. The green line is the price level consistent with the CBO estimate of potential income. The black line is the price level consistent with potential income remaining on the trend growth path of the Great Moderation (both real GDP and the CBO measure of potential income had an approximately equal growth path.) The blue line is the GDP deflator.

The inflation rates consistent with these changes in the productive capacity are shown in the diagram below. The large spike in the red line shows the double digit inflation that would have occurred if money expenditures had remained on target, but potential income dropped as much as real GDP. Note that it returns to the trend inflation rate of the Great Moderation. The green line shows the modestly higher inflation rate that would be consistent with money expenditures continuing on target, but potential income remaining at the depressed level estimated by the CBO. The inflation rate would have risen above the trend of the Great Moderation to 3 percent and then, in recent quarters to nearly 4 percent. The black line shows the trend inflation rate of the Great Moderation. The blue line shows the actual inflation rate.

Since money expenditures fell far below the growth path of the Great Moderation, and are now approximately 13 percent "too low," a return of money expenditures to its trend growth path would result in a substantial change in the price level. The 21 percent increase in money expenditures needed to return to the growth path of the Great Moderation in a year would, at best, be expected to return the price level to the point consistent with real expenditures equal potential income. What would be the implied inflation rate? If potential income had remained at the growth path of the Great Moderation, the inflation rate over the next year would be expected to be 4.8 percent. If potential income has been growing at the anemic rate estimated by CBO, then the inflation rate would be 10.3 percent. And if the decrease in real GDP was entirely due to a decrease in potential income, and the recovery reflects a return to trend, then the inflation rate over the next year would be the remarkable 16.3 percent.

These rather high inflation rates (especially if potential income has been depressed) might suggest a more gradual approach to the long run trend of money expenditures. A two year adjustment would limit the inflation rate if potential income has remained on its long term trend would be 3.5 percent. If the CBO estimate is correct, then a two year adjustment would imply 7 percent inflation. And if all of the decrease in real GDP was due to a downward shift in the productive capacity of the economy, then a return to the trend growth path of the Great Moderation would require 9.5 percent inflation over two years.

I favor an adjusted growth path for money expenditures--a three percent growth path starting at some point in 2008. Such an adjustment not only allows a shift to a zero inflation rate in the long run, it also reduces the the transitional inflation generated by an increase in money expenditures.