[A-List] US economic woe & new economy bull

["Keaney Michael" <Michael.Keaney@xxxxxx>]

America's date with deflation
By Bradford DeLong
Financial Times; Aug 21, 2002

Two years ago, at the peak of the late-1990s boom, the US economy was
slightly overheated. As the unemployment rate fell to 4 per cent and
below, inflation began to creep upwards, rising by between a quarter and
half a percentage point each year. By late 2000 it was clear that
America's gross domestic product was 1-2 percentage points above
potential output - above that level at which aggregate demand balanced
aggregate supply, at least in the sense that there was neither upward
nor downward pressure on inflation.

Today things are very different. America's level of real GDP is running
2 percentage points higher than it was in the summer of 2000. However,
underneath is the extremely strong underlying productivity growth trend
driven by technological revolutions in data processing and data
communications. These technological revolutions have boosted potential
output by perhaps 7 per cent over the past two years. Thus today
America's real GDP is not 1-2 per cent above but 3-4 per cent below
potential output.

How do we know this? Simply look at the unemployment rate: today America
is producing 2 per cent more than it did two years ago, and is doing so
with an unemployment rate not of 4 per cent but of 6 per cent. Moreover,
the unemployment rate is more likely to rise than to fall in the next
year and a half. The consensus forecast is that this year US economic
growth will be positive, but will be significantly less than the rate of
growth of potential output. In 2003, the consensus forecast is for US
economic growth to be about 3.5 per cent - equal to the rate of growth
of potential output, but not enough even to begin to close the output
gap.

With production substantially below potential output, there is downward
pressure on US inflation. We have already seen the US inflation rate
nearly halve in the past two years. This downward pressure is not
expected to lessen for at least the next year and a half. That means
that by the summer of 2004 the US will have an inflation rate - at least
as measured by the GDP deflator - that is less than zero. The US will,
if these forecasts come true, have joined Japan in deflation.

What does this mean? The first implication of deflation is that the
central bank's ability to carry out a stimulative and expansionary
monetary policy is greatly restricted. When inflation is 4 per cent a
year, the central bank can provide businesses with powerful incentives
to take their spare cash and use it to build factories and buy
equipment: if the central bank pushes short-term interest rates near
zero, businesses are faced with the choice between investing in their
business or watching the real value of their cash on hand shrink by 4
per cent a year. When there is deflation, the central bank cannot make
businesses such offers that they are unlikely to refuse: at a deflation
rate of 1 per cent a year, the real value of businesses' cash on hand
grows by 1 per cent a year even if the short-term nominal interest rate
is as low as it can go.

The consensus forecast for the US economy over the next two years is not
a pleasing one. Few - if any - believe that an unemployment rate of 6
per cent is necessary to avoid upward pressure on inflation. Almost all
are looking forward to a period with a substantial output gap: two years
of sub-potential output with unemployment at its current level robs
American households of $800bn
(ý510bn) in real production of goods and services.

More important, deflation rapidly exposes weaknesses in businesses' and
banks' capital structures. If there is the potential for a chain of
bankruptcies that will disrupt the flow of funds through financial
markets, cripple investment spending and bring on a deep recession,
deflation is the best way to turn that potential into an unpleasant
reality.

Most important, however, is that two more years of downward pressure on
the rate of inflation will rob the US Federal Reserve of its power to
stimulate the economy. Today's GDP-deflator inflation rate is about 1
per cent a year, meaning that today's federal funds rate target of 1.75
per cent per year corresponds to a short-term real interest rate of 0.75
per cent a year. If the US price level in two years is not rising but
falling at 1 per cent a year, it will be impossible for the Fed then to
pursue a policy as stimulative as the one it is pursuing now.

It is in this context that the Fed's failure to cut interest rates so
far this year is puzzling. If 1.75 per cent was the appropriate interest
rate last winter, when stock indices were 20 per cent higher than they
are today, it is hard to see how it can be the appropriate rate today.

Furthermore, if 1.75 per cent was the appropriate interest rate before
the shock of revelations about corporate accounting began to drive a
larger wedge of uncertain size between the terms on which the government
can borrow and the terms on which private businesses can raise capital,
it is unlikely to be so today. And if the Federal Reserve wishes - as it
surely does - to preserve its power to offset and neutralise any future
contractionary shocks to the economy, the current inflation rate is
already dangerously low and already leaves it with remarkably little
room for action.

None of this means the US economy is about to run aground. But anyone
who has sailed a yacht knows that it is not enough to be sufficiently
far from shore to have water under your keel. You have to be able to
plot a course that will keep water under your keel. And you have to plot
a course that will keep water under your keel even if Mother Nature
decides not to co-operate.

The first rule of prudence - in yachting and in monetary policy-setting
committees - is to keep away from situations in which one or even two
adverse shocks will cause severe difficulties.

It is thus disturbing that the consensus forecast seems to paint a
picture of the US economy two years hence in which production remains
substantially below potential output, and in which slight deflation has
taken hold and robbed the Fed of its power to offset adverse shocks. The
current course is one that prudent sailors would be scrambling to
change.

The writer is professor of economics at the University of California at
Berkeley