Friday, September 13, 2013

Why No Inflation?

Despite our having a Fed chief nicknamed "Helicopter Ben" and after several rounds of QE, we continue to see inflation remain very subdued. Year-over-year change in the CPI has been trending down for many months:

Source: Bloomberg

As has been the case for expected future inflation:

Source: Bloomberg

And yet the growth of the Fed's balance sheet remains in a healthy uptrend:

Source: Bloomberg

A primary reason for the lack of heightened inflation has been the continued significant slack in the economy. The degree of slack can be seen in the following exhibit:


It shows actual GDP versus potential GDP (as per the CBO), with the difference called the output gap (i.e. slack in the economy).

The output gap recently ballooned to 10%, shown below (blue line):


Yes, our economy continues to gradually improve, but the pace of this recovery continues to fall behind what would've been achieved if the economy was at full capacity. If not for this sizable output gap, and given the Fed's actions, we'd likely see much higher inflation.

It's that simple. I realize there's more than one factor or influence at work here, but until the economy is able to more robustly make up lost ground as it improves, inflation will likely remain relatively benign.

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