Closing output gaps lead to a tradeoff between growth and inflation

The economic and market upcycle will eventually come to an end, but odds are that its downfall will be caused by economic overheating in the US, amid rising financial and fiscal imbalances, rather than escalating trade protectionism.

We hold to our scenario of sustained decent growth across the main economic blocs – with no indicators pointing to a recession or serious slowdown in the US, China or the Eurozone. But while all regions are currently in expansion territory, they are de-synchronized in terms of their phase within the cycle. The first signs of overheating are becoming visible in the US, Europe is still in a comfortable “goldilocks" environment, while activity continues strong in most emerging economies.

To measure how advanced an economic cycle is, economists often refer to the concept of “output gap". This is computed as the difference between actual GDP (Gross Domestic Product) and the potential (or optimal) GDP that an economy could achieve if exploiting its resource base to its full. Although potential GDP sounds like the best output level that can be reached, it is technically possible for an economy to operate above potential (i.e. exhibit a positive output gap). To that effect, resources must be increased, which in turn leads to inflation, since higher wages/prices are needed to attract them. Simply put, a tradeoff between growth and inflation arises as an economy nears its full capacity.

Chart I (page 4) shows the output gaps of several developed economies. Calculations vary substantially, since based on potential GDP estimates that could be inaccurate or changing, but most measures indicate that output gaps are closing across the developed world – have already closed in the US and Japan. History thus suggests that inflation will trend higher going forward.

Near full utilisation of labour in the US is indeed leading to a creep-up in wages, with inflation also arising from scarcer resources. Further monetary tightening would be needed, however, to signal a pending slowdown or recession. In the Eurozone, overheating is still a remote prospect. The substantial slack in employment suggests that the cycle still has legs. As for emerging economies, particularly China, their recoveries from the 2014-2015 commodity shock are well engaged. The virtuous cycle of stabilising currencies and lower inflation has allowed for easier monetary policies. These cyclical tailwinds do now appear to be fading somewhat but are still far from turning into headwinds.

Could potential growth be improved, providing output gap measures – especially in the US – with extra breathing space? Given relatively sticky demographics, the main way to improve an economy's capacity would be to increase productivity. The ongoing expansion has been characterised by weak productivity, owing, in our view, to a combination of factors, including measurement error, weak investment and persistent slack in the labour market. This stagnation in productivity has damaged households' real living standards. However, some evidence suggests that productivity constraints are subsiding. Companies are finally starting to invest again, after a post-Great Financial Crisis decade of capital thriftiness. And, of course, as pertains to the US, the slack in the labour market has essentially been removed (see chart II, (page 4).

A recovery in productivity during coming years might boost economic capacity – delaying the cycle end – but it remains a wild card on which we are not yet ready to fully bet (meaning that we have not integrated this assumption in our computations of potential GDP growth).

In the meantime, the hot issue for central banks and investors is how high US interest rates can go before they begin to hurt – before the underlying flaws (read: excessive debt) of the global economic and financial environment are exposed.

The typical course of events, in the face of a capacity-constrained economy, is that monetary authorities hike interest rates to keep inflation in check, which generally leads to an inverted yield curve, making it either unprofitable or risky for banks to lend.

Alongside the shape of the yield curve or the level of real rates, another way of identifying an excessively restrictive monetary policy is to look at nominal GDP growth relative to the prevailing Fed Funds rate, or even to long-term market rates (see chart III, page 4). When nominal growth dips below interest rates, debt servicing ability is compromised. This was true before the 1990 recession, the 2000 recession and the 2007 depression. But it is not the case today: US nominal growth fully supports debt servicing at current interest rate levels. The same is true in China, indeed across much of the global landscape.

Note: Unless otherwise stated, all data mentioned in this publication is based on the following sources: Datastream, Bloomberg, Lombard Odier calculation.