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such shocks at the moment, such as extreme
drought in Russia last year and unusually wet
weather in parts of Australia now, following on from
unusually cold conditions in the northern hemisphere
in December. Crops are being affected and so food
prices are rising faster than underlying demand and
supply conditions would suggest.
The traditional approach to such shocks is to argue
that, while such effects may last for many months, if
next year’s crops are more normal, the food price
shocks may diminish or reverse. Against this, some
believe that global warming is making extreme
conditions more likely (e.g. the melting of sea ice in
the Barents and Kara seas due to global warming
may be responsible, by changing local wind systems,
for the intense cold spell in Western Europe in
December). There is some probability of this being
correct, so our assumption is food inflation due to
shocks may lessen next year. But there are unlikely
to be significant falls in food prices.
The output gap
The output gap is a little like virtue – it’s somewhat
difficult to define and tougher to measure, but you
tend to find out from consequences when it’s not
present.
In order to calculate the global output gap, we have
taken figures for the past and for forecast periods
from the IMF’s WEO. We calculated the output gap
using a Hodrick-Prescott filter. The results are shown
in Chart 2.
The chart shows a number of striking things:
• The disinflationary trend in the 1990s was
probably greatly helped by output being below
trend;
• The last burst of global inflation in 2007/2008
was associated with output above trend;
• The financial crisis resulted in a considerable
loss of output relative to potential – about 5% on
a global basis. However, output was about 2½%
above potential before the crisis and so the
output gap that emerged was quite small;
• On the basis of IMF forecasts, output should be
about potential in 2011; and
• IMF growth forecasts suggest that output will be
significantly above potential in coming years – by
the most since the early 1980s, in fact.
While the relationship between the output gap and
inflation is not particularly tight on a global basis, in
recent years changes in the output gap have seemed
to offer a good explanation of changes in the rate of
Chart 3: Global Output Gap vs GDP Deflator
Source: Reuters EcoWin Pro
increase in the global GDP deflator (see Chart 3). In
this context, the IMF’s projection of flat inflation from
here but an increase in output relative to potential
seems like dreaming.
Our perspective is that there may be some
shortcomings with the output gap estimates. The
method of filtering may imply a more permanent loss
of capacity than has in fact occurred, for example.
However, the increases we are seeing in inflationary
pressures in a number of traded commodities and in
some emerging markets suggest that, globally,
capacity has closed enough to generate hotspots of
inflation, with a threat of this spreading.
If the IMF’s forecast for global growth is right, a
substantial excess of global demand over supply
looks likely to emerge. This will be spread unevenly –
excess demand being most prevalent in emerging
markets, persisting alongside excess supply in G10
economies. This unevenness will reduce the level of
output at which inflation becomes a problem (prices
are more likely to be rigid downwards than upwards).
The upshot from the output gap analysis is that there
is at least a significant risk that inflation will become a
significant problem on a global basis, even if this is
not yet our main scenario.
Monetary policy
People often think of monetary policy being
summarised by the level of interest rates. Interest
rates are a very useful instrument of policy, but as we
have seen with QE in the US, by no means the only
one. Monetary policy has many aspects and
transmission channels – the level of real and nominal
rates today, expectations of rates tomorrow, the
exchange rate, credit spreads and equity and other
asset prices. We have always been partial to our
financial and monetary conditions index (FMCI). At
Paul Mortimer-Lee 20 January 2011
Market Mover
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