Issue: 41
Sent: 05-06-2006 11:47:52
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Excess Capacity and Inflation - John A Robertson
Rising rates of capacity utilization are reckoned by economists to create inflationary pressures. That is one reason for nervousness about higher interest rates but the adjustment seems less severe than in past cycles.
(See accompanying chart at http://www.thebigpicture.com.au/atc/output_gap.ht m.)
One indicator of whether inflationary pressures are again emerging due to a shortage of productive capacity is the output gap, a measure of the difference between actual GDP and what GDP would have been had the economy been growing consistently at its maximum feasible growth rate.
As long as there is excess capacity, an economy can grow at a faster rate than what might be sustainable over the longer term. However, as the production slack is taken up, this becomes less feasible without inflationary pressures or, if they are to be averted, a round of fresh investment spending (or improved productivity) to enhance economic potential.
Output might be able to exceed its theoretical potential for a period of time but this would normally put such a strain on the economy that some form of adjustment quickly ensues. Examples of that were in the late 19980s and again in the late 1990s when higher goods or asset price inflation resulted (followed by recession).
Both the International Monetary Fund and the OECD calculate output gaps for their member countries. The accompanying chart at http://www.thebigpicture.com.au/atc/output_gap.ht m shows the output gap for the OECD region as a whole (as calculated by the OECD and shown by the yellow line) and for the advanced economies (calculated by the IMF and shown by the blue line).
The last two observations in each of these series include the forecasts of the respective organizations for 2006 and 2007. The red line shows the inflation rate among the advanced economies as calculated by the IMF.
In the chart, a rising line suggests that actual growth exceeds the long term potential growth rate and that excess capacity is being used up. A falling line suggests growth running below itys potential. A reading below zero suggests there is still unutilized productive capacity.
Both the IMF and the OECD expect the output gap to narrow but the closing of the gap is a relatively gentle one and, unlike the experiences of the late 1980s and late 1990s, some excess capacity could actually persist over the forecast period.
The closing gap does signify some potential for higher inflation (and interest rates) but the pressures seem benign by the standards of prior experience.
On this view, companies around the world will have more time to respond to signals that additional productive capacity might be needed. In putting in place the extra capacity, they will help avert the need for demand to be choked off by higher interest rates.
The adjustment process might also be made easier in the current cycle by the strong cash positions of companies around the world (a point which was drawn out in the AllThingsConsidered weekly email three weeks ago.
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