Wednesday, October 14, 2009

Inflation and Optimal Interest Rates

CPI inflation fell to 1.1% last month. This is close to the lower end of the government's target for CPI Inflation (1-3%) In many ways, a fall in inflation below the government's target is more dangerous than being above the inflation target.

The prospect of deflation is particularly dangerous given the levels of personal debt in the UK. Deflation increases the real value of debt and could be a powerful disincentive to spend, hindering any recovery. More on inflation vs Deflation

The fall in GDP, low inflation and rise in unemployment all point to spare capacity and a large output gap.

Some commentators are already talking about tightening monetary and fiscal policy. But, given current data, such a move could prove premature and push the economy back into recession.

Output Gap

According to IMF estimates for 2009, the UK output gap is one of the largest in the OECD at over 3% of GDP.

Definition of Output Gap.
  • The Output gap is the difference between Potential output and actual output.
  • Output gap = Y - Yf where Y = actual output and Yf = potential output.
  • A large negative output gap suggests a recession and spare capacity.
  • A positive output gap suggest actual output is above potential output - Economic growth has exceeded the underlying trend rate leading to inflationary pressure.

Ideal Current Interest Rates

Paul Krugman does a back of the envelope calculation to show according to the Rudebusch version of the Taylor rule:
  • Fed funds target = 2 + 1.5 x inflation - 2 x excess unemployment
The ideal interest rates would currently be -5.6% in the US. - An indication of the depth of the recession.

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