Lowering the Gap and Raising the Bar

yesterday’s FOMC minutes revealed a very interesting development and potentially hawkish policy shift when the committee lowered their assessment of the output gap (emphasis ours).

In the economic projection prepared for the March FOMC meeting, the staff revised up its near-term forecast for real GDP growth a little. Although the recent data on aggregate spending were, on balance, about in line with the staff’s expectations at the time of the previous forecast, indicators of labor market conditions and production improved somewhat more than the staff had anticipated. In addition, the decline in the unemployment rate over the past year was larger than what seemed consistent with the modest reported rate of real GDP growth.

Are they saying that due to the drop in unemployment the economy is growing stronger than what the data implies?  Maybe the reason is because nominal GDP is consistent with pre-crisis growth rates but inflation is higher thus reducing “real” growth.  However employment might be more aligned with nominal growth.

Against this backdrop, the staff reduced its estimate of the level of potential output, yielding a measure of the current output gap that was a little narrower and better aligned with the staff’s estimate of labor market slack.

this is big because one of the main arguments for further QE is due to the perceived spread in the output gap.  In analysis we’ve read the debate is at what point do you extrapolate from and by what growth rate.  Some call for taking 5% nominal GDP from the 2007 level but others think that because that level of GDP was associated with a credit and housing bubble that it should be dialed back a bit.

We favor extrapolating 4% growth from 2000 which would set a much lower bar on where we should be today.  If you take year end 2000 nominal GDP of $10,129t and compound at 4% at year end 2011 we should be at $15.593t v actual of $15.319.  By contrast, if you take $10.129 and compound at 5% you are talking about $17.324t by the end of 2011.  Whether you favor more QE likely depends on where you think we should be today.  The Fed is likely in between those two numbers but the very fact that they have narrowed their spread lends a much more hawkish bent and raises the bar for further QE.  But their reasoning for closing the output gap is key.

In its March forecast, the staff’s projection for real GDP growth over the medium term was somewhat higher than the one presented in January, mostly reflecting an improved outlook for economic activity abroad, a lower foreign exchange value for the dollar, and a higher projected path of equity prices.

uh what?  that gives them a lot of wiggle room if problems in Europe flare back up, the dollar rallies and the stock market crashes again.  In fact if you were a conspiracy theorists you might conclude that Bernanke got more hawkish so he would crash his reflation trade so he could restart the printing press.

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About exantefactor

capital market veteran of over 15 years covering multiple asset classes. Focused on analyzying markets ex ante (before the event).
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