Thursday, September 29, 2011

Thoughts on GDP and inflation

Today's revisions to Q2/11 GDP growth were relatively small and thus not very significant, but I thought this chart was interesting. Note how nominal GDP growth has been running right around 4% for the past seven quarters. It's the composition of nominal GDP growth that has changed; real growth has declined, while inflation has risen (inflation being the difference between the blue and red bars). Put another way, the rise in inflation has corresponded to a decline in growth.

This chart plots the quarterly annualized rate of inflation according to the GDP deflator, the broadest measure of inflation available, and it makes the recent rise in inflation really stand out. We left deflation behind once the recovery started in the summer of 2009. All measures of inflation have risen meaningfully since then. Inflation is not yet at scary levels, to be sure, but it is a fact of current life. We're not really in "stagflation" mode yet (inflation is still too low to be a big concern), but if nominal GDP rises from here without a meaningful pickup in real growth, then it would be the 1970s deja vu.

Note also how inflation by this measure rose from a low of 1.1% in late 1998 (when real growth reached 5.0%), to a high of 4.7% in March '07 (when real growth dipped to a low of 1.2%). This runs directly counter to what the Fed's Phillips-Curve inspired theories of inflation predict: strong growth does not lead to rising inflation—rather, low inflation leads to strong growth, and weak growth lends itself to rising inflation.

This is just one more way of saying that the Fed's efforts to stimulate the economy with easy money and artificially low interest rates are more likely to stimulate inflation than they are to stimulate real growth.


Public Library said...

Very good piece.

Benj you need to better understand this concept. The Fed can push nominal GDP to whatever level they want via inflation/money printing. However, as the charts show, real growth is what truly matters. People are not fooled by nominal GDP.

In terms of real growth, Japanese standards of living have been rising. Just because inflated GDP is not going anywhere does not mean the people are suffering. In fact, the Japanese have benefited from stable prices for a decade or two. Note I said the 'people', not the banks...

jj said...

Scott, saw an interesting interview that speaks to this topic on Wealthtrack this past weekend (available for viewing at with Francois Trahan. He makes the case that with fed funds near zero the Feds effectiveness is greatly reduced and that QE2 was a major mistake on the Fed's part since it resulted in a much weaker dollar and a rise in inflation, this inflation was quickly felt by consumers with the rise in fuel and food costs. What the fed thought was easing was really a form of tightening brought about by higher inflation and consumers rapid reaction to that emerging inflation.

He thinks that CPI is the new key variable in the economy and with fed funds at zero CPI is now playing the role of the fed funds rate. What we effectively had was the short end of the yield curve at 3.6% (CPI) and the 10yr bond at 2%, a negatively sloped yield curve which resulted in the current slow down.

Trahan goes on to make the argument that the fed should focus not on core inflation but CPI. It is nomial CPI that matters to consumption not core inflation. He is for raising rates if we see nominal inflation upticking. The fed did not raise rates when we saw the inflation that resulted from QE2 but the resulting inflation acted as defacto tightening. If the fed doesn't do it, the market will do it regardless. Better for the fed to not let the inflation geni out of the bottle in the first place.

This is a thumbnail description of the interview, he covered quite a bit more. If you have a chance please take a look, would be interested in your thoughts. Thx.

William said...

Scott Grannis wrote:

"This is just one more way of saying that the Fed's efforts to stimulate the economy with easy money and artificially low interest rates are more likely to stimulate inflation than they are to stimulate real growth."

Scott - given your economic theory, what would you expect to happen if the Federal Reserve raised their Federal Funds rate to 0.75% - providing savers at least some relief. - less inflation more real growth??


Frozen in the North said...


Talking of stagflation when inflation is around the "historical level" of the past 10 years -- sounds like wishful thinking on your part.

You need a long term trend of rising inflation to talk about stagflation (although I agree with the "Stag" bit). More importantly, with U3 at 9% and U6 at 16%, and America being mostly a service economy, I don't see much possibility of inflation (except what is imported) since wages are not rising (nor is income for that matter).

There is no doubt, should unemployment fall to 5-6% your argument as to the Fed's policy is more germane, but we are a long long way from that, there are not even enough job creation to address the growing labor force!

McKibbinUSA said...

Let's face it, the unemployment catatrophe in the US is now real and likely permanent, at least through 2025 or beyond -- those in America who hope to prosper through their working careers would be well-advised to think "outside the box" (i.e., "outside the US") -- I would add that US monetary and fiscal policy alike are pursuing "extend and pretend" strategies that seek to extend false hopes to those who are hoping that manufacturing or some form of "green energy" jobs are about to suddenly appear -- now is a good time to take stock in facts and realities vice propaganda -- the best advice one can give anyone seeking to puruse careers in today's global economy is endeavor to become the best in the world at what you do -- now, I'm not saying that all jobs are about to dissappear -- 75% of Americans are still be gainfully employed and will remain employed in the coming years and decades (which was also the case during the Great Depression) -- however, only a delusional fool would rate today's employment sitation in the US as promising -- the employment sacrafices of Americans at large are what fuels today's economy as employment takes a backseat to inflation and growth for at least another decade -- remember, affirmation without discipline is the beginning of delusion -- my best advice to everyone is to exit public employment and entitlement programs purposefully by acquiring world-class skills and dividend and rent-earning equities over a lifetime...

Scott Grannis said...

William: I have answered your question quite a few times over the past year. In short, the Fed should raise rates. That would strengthen the dollar, send a powerful message of future dollar strength, punish speculators, increase investment, increase confidence, reduce uncertainty and generally be a big boost to the economy. And of course savers would also benefit.

Public Library said...

Agree with Scott 110%.

Frozen, you can have inflation with 50% unemployment. Simply print dollars until the sun doesn't shine and you will see inflation.

Benjamin Cole said...

I encourage everyone to read the Money Illusion blog by Scott Sumner, or other bloggers associated with the "market monetarism" school. I really like a fellow named Nunes for his clear expository and use of charts.

Market monetarists are Milton Friedmanites--and remember, Friedman advocated that the Bank of Japan print money back in the 1990s.

If a nation has a wide-scale real estate bust, and the economy is floundering long-term, and there is little to no inflation, then printing money is no shame. It is a practical solution to what ails the economy. There will b winers and losers to printing money---just as there are winners and losers when rates have to go up.

The seminal Friedman article is here:

Unfortunately, I think the current American "right-ing" (and these labels are getting less telling with every year) is conflating activist federal spending with an activist Fed policy.

I am not in favor of federal deficits or economically wasteful government programs, be they defense or social welfare. In this regard, I find Ron Paul interesting.

I am in favor of a vigorous stimulative monetary policy when we have just endured a huge real estate bust across all sectors, there is deflation or close to it, and the economy is 15 percent below trend.

When Scott Grannis (who strikes me as a nice and smart guy, btw) extols the virtues of a strong dollar, I am utterly mystified. The one growth sector we have today in manufacturing, and that is due in large part to exports---and a trade-enhancing dollar.

I think a good case can be made that the dollar has been overvalued for decades due to its role as an reserve currency. I prefer a free-market value on the dollar, and that may be even lower than now, at least against certain currencies.

In short, the right-wing has ossified around certain rallying cries, among them the storied virtues of tight money and the lessons of the Weimar Republic. Or Zimbabwe.

The lesson of Japan is ignored, not the lessons of many, many economies that have thrived with moderate inflation.

And I'll say it again: It is not heresy to want 5 percent real growth and 5 percent inflation vs. 1 percent growth and no inflation.

The point of an economy is innovation, growth and prosperity--not a peevish zeal for stable paper currency values.

Benjamin Cole said...

Public Library--

The stats I see show Japan living standards falling relative to American living standard since 1990. They have increasing income, but growing less quickly than the USA since then. Recently, they have come apart at the seams, of course.

We could argue forever about culture values, structural impediments and much more. But since 1990, and the Bank of Japan fetish for zero inflation, Japan has regressed against S. Korea, China, the USA and even Thailand. They are rapidly becoming a backwater nation. The yen has been strong this entire period---a powerful blow against the "strong dollar' advocates.

Miltn Friedman said so, John Taylor said so, and Ben Bernanke said so--the Bank of Japan should print more money.

Frozen in the North said...


I would suggest that "you" have approval inflation, anything above 100% approval is pure inflation.

Second, inflation is always a monetary phenomenon -- it really cannot be anything else. However, the Zimbabwee model (which is probably what you are thinking of) is not the problem in the U.S. it would be a problem if money was circulating in the economy -- its not, it is stuck on banks' balance sheet.

However, that's not the U.S. problem (for now), and it will not be the U.S. problem for many years (assuming that the US government maintains its insane deficit spending habits).

Unknown said...

I would love to se a chart of GDP and its various growth rates less the Government 20% portion of the number.

What we really want to know is, Is the private sector growing. Throwing $500m at a CA solar manufacturer pumped up the GDP number but it was all air.

Thanks Scott for an awesome blog. An oasis of sanity.


Scott Grannis said...

Peter: Government has added very little to this recovery. Loan guarantees and transfer payments (which account for about two thirds of federal spending) do not count towards GDP. Basically, only government expenditures for goods and services are counted. The private sector has definitely been carrying the water.

Gloeschi said...

I guess the official GDP is measured by first looking at the nominal GDP, then subtracting the deflator. How reliable or realistic is that? What if instead we used the (higher) inflation rate from people like shadowstats? I guess real GDP growth would be much lower. What is your thinking? Thanks!

Scott Grannis said...

Gloeschi: I don't accept the inflation estimates of shadowstats. They are grossly exaggerated, and bear no relationship to reality, in my humble opinion.

Senta said...

The broad measure of inflation include energy and energy costs have been coming down.

Another issue is than banks are not creating credit. They are holding on to the $ on the balance sheet. The velocity of money (M2) has absolutely plummeted.