COLUMN-Fed's Bullard sees little or no global output gap: Kemp

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Friday February 25, 2011 05:59:15 PM GMT

-- John Kemp is a Reuters market analyst. The views expressed are his own --

By John Kemp

LONDON, Feb 24 (Reuters) - Focusing on the global output gap rather than national output gaps might be a fruitful way to assess whether the Fed's monetary policy is fanning inflation, according to the St Louis Fed President James Bullard in a presentation today in Kentucky. [ID:nDYE7DA028]

It is the first time such a senior official at the U.S. central bank has acknowledged that global capacity issues rather than a narrow focus on U.S. unemployment and capacity utilisation might give a better indication of where inflation is headed.

Bullard's comments are significant because he was the earliest and most effective advocate for a second-round of asset purchases (QE2) last summer -- sometimes acting as outrider for Fed Chairman Ben Bernanke and at other times pushing the Federal Open Market Committee further and faster than it wanted to go. [ID:nLDE6721PO]

Bullard admitted the United States has often been analysed as a closed economy but international factors might matter more now than in the past because of globalisation.

In consequence, the global output gap might give a better indication of global conditions, and possibly a better indication of U.S. inflation prospects. (http://stlouisfed.org/newsroom/speeches/pdf/2011-02-24.pdf)

High domestic unemployment might indicate a large output gap in the United States, which policymakers see restraining U.S. inflation. But Bullard poses the question: "What if it is the global output gap that really matters?"

He argues: "The global output gap is probably much narrower, even positive … putting upward pressure on inflation".

Using estimates for global industrial production taken from the Netherlands Bureau for Economic Policy Analysis (CPB), Bullard concludes that there may be little or no spare capacity in the world economy as a whole.

There is clearly a negative output gap for advanced economies reflected in widespread unemployment and under-employment and idle factories. But emerging markets may already be operating at or above their maximum sustainable capacity. The weighted average of the two (the global output gap) suggests a positive gap, perhaps creating upward rather than downward pressure.

Bullard recognises the global output gap hypothesis is fascinating but unproven -- he is floating an idea rather than endorsing it.

He also points to the practical problems of using output gaps to guide policymaking (though they are of the same kind as the problems of relying on national gaps, which remain beloved by many central bankers and other policymakers).

But the thrust of his comments make sense. Panic in the oil markets about possible supply shortfalls and surging prices for everything from cotton and arabica coffee to cocoa, tin, copper, wheat, corn and iron ore, suggest the world economy is operating at or beyond its available spare capacity.

Using ultra-loose monetary policy to encourage above-trend growth in the United States and Europe to re-absorb local "spare capacity" is likely to run up against global capacity constraints and fuel spiralling commodity prices.

In that sense, widespread unemployment and under-employment of resources in the United States and Europe is structural not cyclical.

It results from uneven distribution of demand between the advanced economies and emerging markets -- partly as a result of globalisation and the natural shift of some economic activity to Asia, and partly due to misaligned exchange rates -- not an overall lack of demand on the global level. [ID:nLDE7101AP]

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