Measures of Economic Slack, Cost Pressure, and Inflation
In its November 2009 statement, the Federal Open Market Committee appears to consider the level of resource utilization in the economy an important determinant of future inflation: “With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.” A look at the historical relationship between inflation and two commonly used indicators of economic slack, the output gap and the unemployment rate, makes a good case for the view that slack and inflation are related. Current levels of those and other indicators of resource utilization all suggest a good degree of slack in the economy and contained cost pressures.
The hypothesis that the output gap (the percentage difference between GDP and its potential) is positively related to the change in the core CPI inflation rate over the following year is one of the many versions of the Phillips curve. The idea behind it is that whenever output is above its potential, the rate at which the factors of production, namely capital and labor, is utilized is higher than normal. This puts upward pressure on the cost of capital and labor, and ultimately leads to an increase in the prices of final products and in inflation. Conversely, whenever output is below potential, the low rate of capital and labor utilization puts downward pressure on wages, costs, and prices.
A clear positive relationship between the output gap and the change in inflation can be found in the data. The correlation between the two series is 0.47. The current very low level of the output gap, then, seems to point to an eventual decrease in the inflation rate. However, there are several periods in which the two series appear little correlated, so the relationship may not be that reliable. Other factors, including long-term inflation expectations, monetary and fiscal policy, and the price of imported goods, play important roles in determining inflation. Also, the correlation between the two series is smaller after 1982, so the relationship may have weakened in recent decades. Finally, one should take into account that a very large degree of uncertainty surrounds the current estimates of potential GDP and the output gap.
Another simple and standard version of the Phillips curve states that the unemployment rate is negatively related to the change in core CPI inflation over the following year. The argument behind this hypothesis is similar to the previous one, except that it focuses on the rate of labor utilization, rather than the rate of utilization of all factors of production. An unemployment rate above its natural rate, which we here take as constant over time, puts downward pressure on wages, and leads in turn to lower final product prices.
The data also confirm a negative relationship between the unemployment rate and the change in inflation. The correlation between the two series is −0.37. The currently very high level of unemployment, above 10 percent, may then lead us to anticipate a subdued inflation rate, at least over the short run. As with the output gap and inflation, however, the relationship does not hold during several periods and has somehow weakened during the last decades.
This evidence seems consistent then with the view that the level of resource utilization in the economy contains information about the future short-run dynamics of inflation. Other indicators of resource utilization and cost pressures are likewise correlated to subsequent changes in inflation. Their recent trends also point to low inflation pressures in the near term.
Manufacturing capacity utilization is at a historically low level, 67 percent, indicating a very large level of spare capacity in the economy.
The ratio of unemployed workers to job openings points to the presence of substantial slack in the labor market. The very large current ratio indicates weak labor demand and abundant labor supply, with consequent downward pressure on wages.
The absence of upward pressure on wages is confirmed by the historically low growth rates of the employment cost index (ECI) and compensation per hour.
The prices of final products are affected not only by wages but also by labor productivity. (Higher productivity implies lower production costs for final goods and lower prices.) Productivity growth has remained high during the past recession.
The combination of contained labor compensation and strong productivity explains the current negative growth rate of unit labor costs (the labor cost of producing one unit of output), which is exerting a strong downward pressure on prices.
Several measures consistently show that the current level of economic slack is elevated. Given the historical relationship between measures of resource utilization and the subsequent change in inflation, this slack suggests that inflation will remain subdued in the near term.