Abstract
This paper estimates the extent of spare capacity in the U.K. economy using a range of methodologies pointing to an output gap and the behavior of inflation during large output gaps. The usefulness of fiscal rules in supporting fiscal consolidation is generally positive, and a more permanent rules-based fiscal framework is required. The banking system has recovered fast; however, the sustainability of the sector’s recovery is still uncertain, and risks remain. An update on reforms to the financial sector’s regulatory and supervisory framework is also provided.
II. Inflation Dynamics during Episodes of Persistent Large Output Gaps1
This note documents the behavior of inflation during historical episodes of persistent large output gaps in advanced economies. Generally, such episodes brought about significant disinflation, although inflation tended to bottom out at low positive rates. Recent developments in advanced economies are consistent with the disinflationary effect of PLOGs.
1. Most advanced economies are projected to recover only slowly from the global financial crisis, with output remaining below potential for several years to come. This outlook has prompted concerns that inflation might undershoot official targets for an extended period. The assumed link between spare capacity and disinflation is familiar from traditional Phillips curve arguments, but has support in New Keynesian models as well.
2. However, not everyone agrees that excessively low inflation, or even deflation, is in store. Many official forecasts show inflation converging back to target rates well before output returns to potential; and some observers even view risks tilted to the upside, predicting an inflationary sequel to the financial crisis. What’s more, the apparent disagreement relates not only, or even primarily, to the current cyclical outlook—most observers agree that there is sizeable slack—but to the moderating impact such slack will have on inflation, relative to other factors.
3. The standard way of analyzing this issue is to estimate the slope of the Phillips curve, often in a single-equation approach using instrumental-variable methods. Yet, these efforts are fraught with many difficulties, notably the scarcity of time series data for inflation expectations, weak instrument problems, and the complications arising from nonlinearities, nontrivial lag structures, drift in mean inflation, and nuisance factors (like exchange rate or oil price shocks).
A. Tracing Inflation Dynamics During PLOG Episodes
4. In a recent IMF Working Paper, we sidestep such estimation issues by focusing on a simpler event study approach. Specifically, we trace inflation dynamics during historical episodes in advanced economies where output remained significantly (at least 1.5 percent) below potential for more than eight consecutive quarters. In so doing, we limit attention to a segment of the Phillips curve that seems particularly relevant today, i.e., situations of protracted economic slack. It is clear that stylized facts documented for the past can only be a rough guide to the present, but as our sample includes a total of 25 episodes in 14 countries from the last 40 years, it provides a broad perspective on inflation outcomes during episodes of persistent large output gaps (PLOGs).
B. Main Results
5. A few key findings stand out:
There is a clear and pervasive pattern of disinflation during historical PLOG episodes. Moreover, in the two atypical cases where inflation failed to decline, the observed increase was negligible and occurred from exceptionally low initial rates of inflation.
CPI Inflation at the Outset and End of PLOG Episodes 1/
(percent, sa)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A002
1/ Episodes of persistent large output gaps as listed in Table 2 of IMF Working Paper 2010/189.CPI Inflation at the Outset and End of PLOG Episodes 1/
(percent, sa)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A002
1/ Episodes of persistent large output gaps as listed in Table 2 of IMF Working Paper 2010/189.CPI Inflation at the Outset and End of PLOG Episodes 1/
(percent, sa)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A002
1/ Episodes of persistent large output gaps as listed in Table 2 of IMF Working Paper 2010/189.The disinflationary dynamics appear to be supported by weak labor markets, with high and/or rising unemployment, and falling nominal wage growth and real unit labor cost. This pattern points to the expected link between spare capacity and diminished cost pressures facing firms. In several cases, falling oil prices further helped the decline in inflation. Nominal exchange rates, in turn, show no uniform trend during PLOG episodes, but appreciating currencies are systematically associated with faster disinflation in the cross section.
Overall, the relationship between initial and final inflation rates seems roughly proportional, suggesting that countries with high initial rates of inflation experience greater disinflation in absolute, but not relative terms. This result remains intact if we control for the different length of individual episodes, by considering annualized changes in inflation rates.
That said, the dynamics differ somewhat across time periods. In pre-1990 episodes (marked by relatively high initial inflation), disinflation tended to proceed rather steadily throughout the episode. The more recent (low-inflation) episodes, by contrast, featured most of the disinflation early on, followed by a timelier bottoming-out. Indeed, inflation generally stopped falling, and instead stabilized or even increased, once it had reached a low positive rate. Although some of this pattern could be a statistical artifact related to temporary inflation shocks, the strong clustering of such observations in post-1990 episodes points to more fundamental reasons.
Quarterly CPI Inflation during PLOG Episodes by Time Period 1/
(percent, saar)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A002
1/ X-axis denotes quarters, with t-0 the first quarter of each episode.Quarterly CPI Inflation during PLOG Episodes by Time Period 1/
(percent, saar)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A002
1/ X-axis denotes quarters, with t-0 the first quarter of each episode.Quarterly CPI Inflation during PLOG Episodes by Time Period 1/
(percent, saar)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A002
1/ X-axis denotes quarters, with t-0 the first quarter of each episode.C. Why Might Disinflation Peter Out at Low Positive Rates of Inflation?
Two explanations, in particular, come to mind.
6. First, the literature has emphasized the enhanced credibility of central banks in preserving price stability in recent years. Such credibility would be apparent not only in low average rates of inflation, but also in a strong anchoring of inflation expectations. If price-setters trust the central bank’s commitment, they have less reason to respond to short-term variation in marginal cost, and a weaker relationship between output gaps and inflation may ensue. This argument accords with the notion of a “flattening Phillips curve,” which some authors have documented.2
7. Second, already-low inflation might inhibit further disinflation because of downward nominal rigidities, which appear to be common in wage-setting; see Akerlof et al. (1996) and Benigno and Ricci (2010). This explanation would also account for the scarcity of outright deflation in our sample. Given the resistance to nominal cuts, it may take truly exceptional circumstances (perhaps epitomized by Japan’s experience during the last two decades) to create negative wage and price dynamics.
Implications for the current inflation outlook…
8. Taken together, the historical evidence points to a clear disinflationary effect from persistent large output gaps, at least until inflation has declined to very low positive rates. For countries currently facing protracted economic slack, this would suggest limited upside inflation risk. Yet, such an inference must obviously be taken with a bit of caution, mainly for two reasons:
Historical experience, especially from the 1970s, shows that real-time assessments of spare capacity may be subject to large ex-post revisions. Similarly, economists might be overestimating the extent of slack in advanced economies today. Countering this concern is the profession’s awareness of the lessons from the 1970s. Indeed, most economists already factor in that the global financial crisis has not only depressed demand, but also curtailed supply capacity.
Time-invariant relationships are scarce in macroeconomics, and even patterns reliably documented for the past might not persist under today’s particular circumstances. One often-cited argument relates to the exceptionally aggressive policy response to the recent crisis. Indeed, with policy rates (essentially) at zero, several central banks have resorted to money-financed bond purchases. Although there is no obvious, let alone mechanical, link from these unconventional policies to high inflation, they might conceivably interact with fears about high public debt to undermine trust in the currency. Yet, policymakers are well aware of this tail risk and, in many cases, have already laid out concrete consolidation plans to ensure fiscal sustainability. As a result, fiscal policy is likely to support, rather than counteract, disinflation over the coming period. Meanwhile, inflation expectations have shown no signs of being unhinged by quantitative easing.
… and a look at recent data
9. With these aspects in mind, it is instructive to consider actual inflation trends during recent quarters. Using the same definition as for our historical sample, we identify 15 ongoing PLOG episodes in advanced economies. Relative to the historical patterns, the decline in output is unusually large this time, although labor markets have held up better in relative terms. In fact, widespread labor hoarding appears to have driven up average unit labor cost in many countries, even as nominal wage growth has eased. Another striking feature is the rollercoaster ride of oil (and other commodity) prices, which first fell precipitously but subsequently recovered some of the lost ground. While these swings had a considerable impact on headline inflation, a general downward trend is nonetheless apparent. And once food and energy prices are stripped out from the CPI, the pace of disinflation actually looks very similar to the historical precedent: median inflation has eased by about 20 percent of the initial inflation rate p.a. so far—about the same rate as in earlier PLOG episodes.
CPI Inflation during the Ongoing Downturn Relative to Historical PLOG Episodes
(quarterly, saar, percent)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A002
CPI Inflation during the Ongoing Downturn Relative to Historical PLOG Episodes
(quarterly, saar, percent)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A002
CPI Inflation during the Ongoing Downturn Relative to Historical PLOG Episodes
(quarterly, saar, percent)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A002
D. Conclusion
10. Historical episodes of persistent large output gaps in advanced economies show a clear pattern of disinflation, supported by weak labor markets and, in many cases, falling oil prices. The most recent experience since the beginning of the financial crisis is consistent with this pattern. Indeed, inflation in many advanced countries has now declined to the very low rates at which disinflation typically petered out during past PLOG episodes, probably reflecting well-anchored inflation expectations and downward nominal rigidities. Thus, while upside inflation risks should be limited in countries facing continued economic slack, a slide into outright deflation should not be taken for granted either.
References
Akerlof, G., W. Dickens, and G. Perry, 1996, “The Macroeconomics of Low Inflation,” Brookings Papers on Economic Activity, No. 1, pp. 1–59.
Benigno, P. and L. Ricci, 2010, “The Inflation-Output Trade-Off with Downward Wage Rigidities,” NBER Working Paper No. 15672.
Kleibergen, F. and S. Mavroeidis, 2009, “Weak Instrument Robust Tests in GMM and the New Keynesian Phillips Curve,” Journal of Business and Economic Statistics, 27, pp. 293–311.
Meier, A., 2010, “Still Minding the Gap—Inflation Dynamics during Episodes of Persistent Large Output Gaps,” IMF Working Paper 2010/189.
Nason, J. M. and G.W. Smith, 2008, “The New Keynesian Phillips Curve: Lessons from Single-Equation Econometric Estimation,” Federal Reserve Bank of Richmond Economic Quarterly, 94 (4), pp. 361–395.
Prepared by André Meier (EUR).
See, for instance, Kleibergen and Mavroeidis (2008). By contrast, Nason and Smith (2008) find no evidence for a parameter change. Our own study also shows similar overall disinflation in relative terms during pre-1990 and post-1990 PLOG episodes.
