The widespread confusion and angst emanating from the economics profession comes from a single calculation. At the core of monetary targeting is the mathematical expression of a systemic target. Called the output gap, economists seek to identify economic potential in order to measure and gauge actual output. In so doing, they believe they will identify periods when stimulative or restrictive measures are most appropriate.
It might even be an understatement to call the output gap estimate the heart of monetary science. No policy is designed, let alone implemented, without its guidance. The weighty decisions over interest rate regimes and credit conditions are carried out in direct harmony with this approximation.
In 2004, the Federal Reserve finally reversed its "stimulative" interest structure after more than two years of then-record low rates. The timing of the movement was keyed around the Fed's estimate that actual economic output was closing the gap with its models' estimates of long-term potential, belatedly recovering ground the central bank thought lost in the aftermath of the stock collapse. Monetarists, with good empirical reason, believe that stimulative credit conditions applied to an economy nearing or at potential will lead to inflation. Therefore, as actual output began to pick up steam that year, the Fed wanted to cautiously head off any inflationary pressures before they began to build.
As a result of the Great Recession, on the other hand, the Fed has instituted a zero interest rate policy (ZIRP). Chairman Bernanke is continuing in the ideological footsteps of his predecessor, Alan Greenspan. The reason for ZIRP and its continuation into the foreseeable future is, again, the output gap. Based on current calculations, the economics profession believes that recent economic output is far below its potential - so far below that keeping ZIRP for four or even five consecutive years is not at all troubling to Mr. Bernanke. As such, current thought believes that there is sufficient "slack" to allow monetary policy to be continually and persistently aggressive.
This produces the confusion that Mr. Bernanke expressed a few weeks back. Despite very aggressive monetary measures, there has been little movement toward economic recovery. Referring to this as bewildering "headwinds", the Chairman echoes the broader sentiment of economists and their mathematical interpretations. For some reason monetary policy is not working as they expect.
Essentially, the output gap calculation is a measurement of potential based on the idea of an employment/inflation tradeoff. In simple terms, if inflation is low and expectations are steady, such conditions are thought to signify an economy that is below potential. Because monetarists and economists believe that inflation is the result of full employment (and only full employment), benign inflationary conditions indicate sufficient margin to push the economy to a higher output level, leading to expanding employment conditions.
In the nuts and bolts of monetary policy, inflation defines full employment, and thus economic potential. In the current situation, the Fed believes that inflationary pressures are quite low and inflation expectations are stable, so given the large "slack" in labor and capital resources it has concluded that the economy needs significant and sustained stimulation to get back to full employment.
But what if inflationary pressures are not low and expectations are not stable? In the circumstances of the output gap it would mean that whatever level of employment and output currently exists is at or above potential.
Monetary evolution has defined inflation to be a rise in the general level of prices. That is an important qualification, with "general" being the operative word. Commodity price increases are specific so they cannot, economists believe, represent true inflation. Any upward movements of commodity costs are held as "transitory" rather than directly inflationary. Since they currently exist during a period of weak wage income growth, commodity prices are believed to be nothing more than temporal anomalies that will revert to their mean without causing lasting harm.
As much as the representation of current economic difficulties, commodities, lie outside the accepted definition of inflation, the two most important economic and monetary events of the past twenty years also fall outside the Federal Reserve's accepted canon. For some reason, the defining economic characteristics of recent history are intentionally set aside when figuring economic potential. The two largest asset bubbles in history have no place in the concept of the output gap as it is currently construed. The best explanation from economists for not including asset bubbles is that there is no objective methodology for discerning an asset bubble from a "normal" bull market.
Setting aside the apparent similarities of economists' feelings on asset bubbles and the Supreme Court's view of pornography (they know them when they see them, but otherwise cannot ascribe a technical definition to either), there should be at least an effort to incorporate exactly how household and financial intermediaries' balance sheets fell into such damaging disrepair during an economic period when apparently no misalignment in monetary policy occurred. Since credit and money are linked through interest rates and wholesale money markets, there should be a direct link between the calculation of the output gap, the monetary policy set to it, and the wider consequences of massive asset price inflation. How could so much debt be created and distributed if monetary policy was properly calibrated to an economy below its potential?
If we think of the Fed's narrow definition of inflation and how it relates to that potential, the symptom of generic inflation (an expanded definition beyond the narrow assumption currently employed) simply means that the economy is experiencing activity above that ephemeral concept of potential. That further indicates that a growing proportion of economic activity is unsustainable and artificial. In that case, the economy experiences a negative output gap (where actual output is above potential) where the Fed would change its stance and move to restrictive policies and interest rates - restrictive in that they would reduce incentives to create credit, making money generally more expensive and costly to bank capitalization.
Knowing these parameters, it is hard to see how the asset bubbles of the late 1990's and 2000's were any different than the textbook definition of a negative output gap. The dot-com frenzy created economic activity tied to price pressures, in this case stocks, that was clearly unsustainable and artificial. The amount of household debt added and the resumption of equity extractions tied to corporate credit (through stock buybacks, mergers and privatizations) during the "best" days of the stock bubble attest to the monetarism of that period. What would the "wealth effect" of the late 1990's have looked like without so much cheap consumer and corporate credit?
The housing bubble was essentially the same process as the dot-com bubble amplified by the dramatic shift in marginal credit creation to securitization and revolutionary changes in balance sheet capacity - all of which were the responsibilities of the Federal Reserve as regulators of money supply and interest rates. In economic terms, it was simply another elongated period of artificial economic activity; only the inflationary channel had substantially changed from equities to real estate. The Fed knew that housing prices were "frothy" and that housing related GDP was at its historical upper limits (defined as two standard deviations from the historical baseline), but it never moved to incorporate this data into its understanding of the output gap.
In the orthodoxy of modern monetary thought, though, the housing bubble never pushed through to sustained wage pressures. Holding onto that limited understanding the Fed was blinded to a worsening, overheating economy despite several obvious signs that something was amiss. Not the least of which was the non-existent savings rate for households that appeared in 2005. At the very least, that extreme condition should have been the final warning that wage pressures were never going to register an economy already so far out of balance.
The change in the historical savings rate was really just a substitute for wage pressures. That collapse was the final stages of the longer-term alteration of consumer spending patterns further and further away from the traditional base of wage income. In the absence of so much cheap and available credit, households would have been more likely to demand sustained increases in wages before committing to higher spending levels. Credit availability and net worth growth through price action displaced the role that earned income typically held, and it was all tied to asset price "inflation".
I believe this is the sense that most people have intuitively (houses as ATM's). Despite the false comfort of the Fed's math, there is widespread recognition of the fact that so much economic activity was tied to housing that it cannot possibly revert back to the way it was. Put another way, malinvestment due to an economy operating above potential allocated resources and production capabilities toward industries and sectors that will not be able to conduct productive growth in the absence of accelerating real estate prices. If there are anywhere near the 18% surplus in residential dwellings that some have calculated, a serious misallocation if there ever was one, then we cannot expect construction or mortgage jobs to return as they were. That ship has sailed, crashed on the rocks and sank with all hands lost.
The dramatic shift or dislocation that occurred in 2008 and 2009 was, as hard as it will be for economists to admit and change their models, really just an economic reversion to true potential. Worse still, if we think about that shift within the realm of financial intermediation and ongoing asset devaluation, then it might not have run its full course. The economy may not yet have devolved enough to completely erase the negative output gap that persisted while monetary policymakers were convinced of the opposite.
If the economy was indeed channeling above-potential growth into asset price inflation, then at some point, had the Fed recognized it, restrictive measures would have been enacted (certainly more aggressive than the "measured", careful interest rate increases that were belatedly enacted in 2004 and 2005). Restricting credit and economic growth would have led inflationary pressures to recede and, in terms of the housing bubble, it would have meant a decline in housing activity and prices to erase and fix artificial misallocations.
Absent that Fed intervention, the financial system and economy are simply implementing the same prescription, albeit in a chaotic and uneven fashion. The asset deflation seen since 2006, that turned to panic in 2008, really has served to accomplish the same task as restrictive Federal Reserve policy. So no matter how aggressive monetary policy becomes, the economy refuses to bend to it. Perhaps the natural economy knows better than the math?
Not only were real estate prices and activities inflated during the period, but as the breakdown in household savings amply demonstrate, so was consumer spending. If consumer spending was inflated by malinvestment, then some portion of corporate profitability and business spending must have been as well. All that economic activity tied to asset inflation, predicated on an economy operating above its true potential, is collapsing precisely because its monetary foundations are corrupt. The devaluation in credit assets is simply the most tangible, outward description of a systemic revaluation of true potential.
Since the question of debt pricing in so many sectors is still frustratingly unresolved, it is very likely that the re-adjustment is still trying to progress against the grain of monetary intervention. For the output gap, it means that economic output may still be well ahead of potential, further signifying that "accommodative" policy measures are simply creating new and different forms of inflation and malinvestment. The prices of commodities and stocks are the speculative excesses of yet another period of misaligned policies.
What initially was believed to be a liquidity crisis is really a full-blown crisis of solvency. Such an extreme condition can only be a product of a system so far out of balance that it requires such dramatic steps to unwind. A healthy, efficient economy would never have allowed so much inequity to build and fester. Had the system operated within the parameters of potential it simply would not have been built on a foundation of debt. Insolvency could have only come from monetary mismanagement, a collusion of finance and mathematics.
If only economists and monetary policymakers would allow themselves to move beyond the simplified tradeoff of narrowly defined consumer inflation to employment they might rediscover natural economic progressions. What is more believable, that the economy persists in a state of weakness far below its potential, apparently unwilling, despite powerful and persistent doses of monetary intervention, to return to the historical average that it achieved when asset bubbles were the norm, or that the baseline assumption of that potential was, and continues to be, too high and that the Great Recession was simply a natural self-correction to get the economy out of its paper-price dependency?
Instead of trying to re-inflate asset prices in a vain attempt at fostering a "wealth effect" through credit production and dispersal, all in the name of closing an output gap that likely does not exist, monetary policy could be allowing price discovery and market discipline to promote re-allocation based on productive investment instead of recycling incentives toward speculation and the financial investment that brought us to insolvency to begin with. Yes, this would be painful in the short-term, but the missing recovery is waiting on the other side of it.
Jeffrey Snider is President and Chief Investment Officer of Atlantic Capital Management, a registered investment advisor.
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