Executive Summary
Central banks seek to shepherd the economy through cyclical shifts
If an economy runs too hot inflation can take hold, increasing the costs of living for that economy’s population
Should an economy run too cold, with more supply than demand, an economy suffer mass unemployment
Central banks seek to keep prices stable and unemployment low
To do this they raise or lower interest rates and in extreme cases commit to asset purchases or sales
Dovish policies (rate reductions and asset purchases) are intended to stimulate demand, hawkish policies (rate hikes and asset sales) encourage saving, pushing demand into the future
This blog explores whether central banks correctly diagnosed whether the economy was running above or below ideal capacity in the wake of economic lockdowns
It concludes that a collective misdiagnosis of the ‘Output Gap’ - the difference between an economies ideal output and its actual output, meant that central banks implemented exactly the wrong policies at precisely the wrong time.
The result being the soaring level of inflation we are seeing today.
What a shower
Getting into a shower with old or faulty plumbing can give you a quick lesson on how hard it is to control even a simple system. Initially the water runs cold - you turn up the temperature, nothing happens. You nudge it a little warmer, still nothing; you yank the dial all the way around to the hottest setting. Still the water runs freezing cold. Then suddenly the water temperature is like the surface of the sun, you nudge it back to cold, it stays hot. Depending on the age of the shower and the quality of the plumbing you may spend a good deal of time trying to tweak the dial to avoid the extremes of freezing cold waterfall or boiling lava-rain.
This is an example of control lags and overshoot. It can take a while for an input change to take effect. Many systems exhibit this pendulum-like effect where a system overshoots and undershoots its target in response to inputs and stimulus
Perhaps then we should have some sympathy for central bankers who seek to moderate the economy. Their main dial is short term policy rates with an additional lever of quantitative easing/tightening (bond purchases or sales). And what they are seeking to control is an astonishingly complex system.
The Output Gap
A key economic indicator that policy makers consider is the 'output gap'. This is illustrated in figure 1 below. The economic theory that governs central bank policy can be described as follows:
As people become more skilled, as education & technology advances and as the workforce grows, more production capacity is achieved. This explains why the GDP trend is nearly always upward. But it can and does decline in the event of major shocks such as wars, deep recessions for other shocks
While hard to precisely quantify there exists an ideal sustainable rate of economic growth over time.
This level of growth will keep prices stable and unemployment low.
When demand outstrips supply - this happens when actual GDP growth is higher than the long-term trend rate, we get inflationary pressures.
Firms hire more staff to meet demand
Wages rise in order to attract more production capacity
Inflation sets in
Here the economy is ‘overheating’. With more demand than the economy can supply central banks would look to raise rates. As rates rise and rise saving for future consumption becomes more desirable
When demand falls below supply - I.e. when actual GDP lower than the capacity of the economy there is a glut of supply.
Firms lay-off staff as there is already too much supply relative to demand
Wages fall as workers are keen to remain in the workforce
Inflation falls, in the case of severe recessions stagflation or deflation can occur
Here the economy is in need of stimulus. Interest rates fall (and as we have seen may go negative) to deter saving and encourage consumption.
Much like the shower or the pendulum it is common that the economy overshoots and undershoots. This can be seen in the figure below. Recall that for any economy there exists an optimum or equilibrium level of production that will minimise unemployment and provide price stability. This equilibrium capacity is shown as the orange line in figure 1. Policy makers try to steer the economy as close to this line as they can, but there will inevitably be deviations from this ideal capacity - the actual GDP is shown as the green line.
Figure 1 - The output gap, shown with four phases of an economic cycle.
There are thus four distinct phases in an economic cycle that will influence central bank policy. Each member or the MPC, FOMC or other committee will use data as well as their skill and judgement to determine what phase the economy is in. Along with other considerations this will determine their position on what direction monetary policy should take (or by analogy; in which direction and by how much to turn the shower dial). This is very often a majority decision, rather than a unanimous one.
Expansion. A positive output gap and GDP growing above trend rate. Rate tightening is appropriate to stave off inflation. (In figure 1 above the green line is above the orange line and moving further away).
Peak. A positive output gap, but the rate of GDP growth is below the trend rate. Interest rates policy is neutral and nuanced to lower the risk of deep recession. (Green line above the orange line and closing).
Recession. Negative output gap and GDP growth below trend. Rates should be lowered to stimulate demand. (Green line below the orange line and deviating further).
Trough. A turning point in the business cycle. While GDP is below capacity its trend is increasing and the output gap is closing. (Green line below the orange line but closing). Nuance and caution are needed. Too early a tightening risks choking off growth. Too dovish a policy could lead to the economy overheating stoking inflation.
A understandable, but fatal, misdiagnosis
As the pandemic took hold governments of almost every nation locked down their economies to to slow the spread of the virus. Central bankers of G20 economies believed that aggregate demand would decline, accordingly output gaps would become increasingly negative.
Broadly speaking what central banks thought was happening is illustrated in figure 2 below.
Figure 2 - Central banks thought that supply shocks were transitory. Consequently they believed that the ideal or equilibrium capacity of the economy was greater than it was.
They believed that actual output would drop below capacity. The playbook in this scenario is to loosen rates and if more stimulus is needed implement additional QE through bond purchases. This is exactly what they did. They legitimately believed that the green line was below the orange line in the figure above.
Supply shocks were clearly not 'transitory' (as some central bankers asserted)
However what they overlooked was a persistent reversal in supply chains. The past two decades have seen a huge increase in globalisation; where price became the major and in many cases sole determinant in choosing a supply chain. In aggregate companies and individuals sought the lowest cost of product and services. The economy responded by seeking & providing economies of scale, offshoring service workers and sourcing the lowest cost manufacturing and distribution.
But the in the wake of the pandemic that is simply no longer true. Security of supply, geopolitics and ESG play a much greater role. Less efficient supply chains must result in higher costs and hence higher inflation. But more perniciously they reduce the optimum or equilibrium level of GDP. The level that maximises price stability while minimising unemployment.
The policy makers at central banks sincerely believed that these supply chain disruptions were ‘transitory’. But the reversals in globalisation have been shown to be much more persistent than they had assumed.
The 'positive void co-efficient'
The figure below illustrates the misdiagnosis. Policy makers at Central Banks believed that GDP was stalling and was below equilibrium capacity. (In the chart below the orange line shows the trajectory of actual GDP pre-pandemic. The purple trace on the right shows the drop in actual GDP due to shocks brought about by lockdowns). They did what they believed to be right in such a circumstance. They cut policy rates and increased QE operations.
But the ideal capacity of the economy was lower than they had thought.
Figure 3. Hindsight is 20/20... In believing that supply shocks were transitory and not permanent central banks calculated that actual GDP was below ideal (in the figure above the purple line of actual GDP is below the green line of where the central banks thought 'ideal' GDP was), when in fact the economy was running hot relative to its equilibrium/optimum level (shown as the teal line in the chart above)
Recall that any economy has an optimum level of economic activity to minimise unemployment and maintain price stability. Real activity will always be above or below that optimum level. With increased costs in supply chains this optimum level had fallen below the actual level of GDP. (In figure 3 above this is shown as the shift between the green line - where central bankers thought the optimum level was - and the teal line - where the optimum GDP had in fact moved to).
Cutting rates and expanding bond purchases turned out to be exactly the opposite of what central banks should have done. The problem was not execution, it was misdiagnosis.
If actual GDP is above ideal then the economy is overheating with demand far greater than supply. Cutting policy rates & increasing QE further stoked that demand. At the same time furlough schemes, the CARES Act and other stimulus packages were out of necessity putting money in people's pockets.
"Inflation is caused by too much money chasing after too few goods."
- Milton Friedman
Conclusions
A keenly watched metric is the output gap.
A high and increasing output gap usually requires rates to rise
Conversely a low and worsening output gap would normally herald rate cuts.
Central banks correctly identified a drop in demand associated with government imposed lockdowns
What they failed to do was correctly diagnose secular, not idiosyncratic shifts in global supply.
Sourcing lowest price globally became less important than security of supply
On its own this increased inflation, but it also introduced a permanent reduction in the capacity of the global economy.
With actual capacity above this 'new equilibrium', with too much money from stimulus and furloughs chasing too little products and services the decisions by central banks to cut rates has contributed to high levels of inflation. (High meaning high single digits in many countries with low double digits in others).