Mizuho Insights – The (Output) Gap Between Reflation & Inflation Risks

“Strong am I with the Force. But not that strong.” – Master Yoda, Star Wars Ep. VI: Return of the Jedi

In a Nutshell: Fears of untethered inflation down the road from extraordinary policy stimulus are understandable, but nevertheless misguided. To be sure, unprecedented policy stimulus – in particular, the conspiracy of exceptionally large QE and never before seen levels of fiscal stimulus – will inevitably unleash cost-push pressures. But that is a feature, albeit by way of by-product, of any effective reflationary policy (monetary/fiscal stimulus). Whereas, reflation-induced cost-push does not necessarily evolve into an inflationary spiral/overheating requiring policy response. Not even if layers of cost-push are accentuated by vaccine optimism and capacity constraints colliding with policy-induced cash deluge.

Reason being, record negative output gaps across the board negate, or at least override, the risk of run-away inflation. Crucially, gradual rather than robust pace of re-narrowing of the output gap is consistent with transitory cost-push (from reflation) dissipating amid weak wage-price dynamics. In other words, negative output gaps serve as a circuit-breaker between transitory cost-push and self-sustaining demand-pull inflation. The upshot is that monetary and fiscal stimulus need not be hastily yanked given risks of unhinged inflation expectations wreaking havoc are subordinated to the greater danger that too little. Master Yoda’s words of “not that strong” ring true of inflation with respect to “the Force” of reflation.

Reflation & Inflation: What’s the Difference?

For the purposes of context and clarity, reflation refers to policy (monetary/fiscal) initiative aimed at reviving demand. Whether this is driven by price (interest rate) or quantity (QE) aspects of monetary policy and by tax (cuts) or enlarged fiscal spending are just details. Regardless, any effective reflationary policy ought to constitute a pick-up in prices, typically led by cost-push pressures on demand recovery expectations. Whereas inflation is defined to be the generalized increase in prices; whereby cost-push pressures entrench as demand-pull pressures.

More specifically, the “inflation” that central bankers are committed to guard against, entails a more aggressive iteration of this brand of demand-pull inflation; which exceed policy threshold and threaten to impair future growth prospects. And so, the wider point is while (transitory) cost-push being a feature of effective reflationary policies, run-away inflation is not an unavoidable outcome. In other words, reflation need not always be a victim of its own success; ending up hijacked by risks of inflationary spirals.

The Inflation Debate …

The argument rests on inflation beyond base effects and the notion that cost-push pressures will not be transitory; and the concerns are not without bases. Admittedly, unprecedented policy stimulus constituting lower for longer rates, record quantitative easing and exceptional fiscal spending, push the envelope on pump-priming; thereby setting the stage for a sharp jump in inflationary pressures.

Especially as demand recovery from “the other side” of the pandemic conspires with a steep step-up in (pent-up) on “herd immunity” and capacity constraints to accentuate inflationary pressures (Figure 2); and aspects of this are already observed in the sharp surges in commodity price and shipping cost related to production and logistics capacity constraints respectively (Figure 3).

… Dampened by the (Missing) Wage-Price Link

However, a key link between cost-push inflation, which is typically transitory in isolation, and entrenched inflation risks is the demand-pull mechanics that are predominantly driven by wage-price spiral. Simply put, self-sustaining inflationary expectations require a feedback loop of rising prices and wage growth expectations.

And this is where the rubber on inflation expectations fails to meet the reflation road. Fact is, into this nascent recovery out of the pandemic, aggregate demand restoration is more likely than not set to be uneven, and tentative, if not fragile. That is, even if spots of pent-up demand restoration, a lot of initial demand overshoot may be short-lived and subject to substitution. Crucially, as fiscal support fades, households and firms may be subject to the double-whammy of higher costs (eroding discretionary income and margins) and subdued wage/revenue growth amid lingering uncertainty and economic restructuring.

And so, the conspicuous absence of wage pick-up in the initial phases of post-pandemic recovery, likely through the first half of 2022 suggests that inflation from cost-push factors may (at least initially) be considered as benign and transitory with diminished risks of persistent demand-pull pressures.

Output Gap Circuit-Breaker
Critically, the deeply negative “output gap” (Figure 4) – a measure of how far below output levels otherwise suggested by potential growth an economy is – acts as a “circuit-breaker” for potential cost-push inflation pass-through to demand. Fact is, global economies well below their capacities will have a lot of “slack” within which cost pick-up may be assumed (given both weak demand and supply adjustments to response to price increases). In which case, inflationary pressures may be subdued by the dampener effects of spare capacity in firms, if not weak demand.

Typically, a large, negative output gap (in multiples of respective GDP) is inconsistent with wage-price spirals due to constraints on both firms and households to increase demand and wages correspondingly. Especially if the negative output gap is only expected to close/narrow gradually.

And to be clear, even with stellar-looking headline growth (flattered by base effects) expected in 2021, output gaps are expected to only narrow gradually, if at all (Figure 1); reinforcing the view that binding inflation risks are some way off. In turn, this suggest that policy makers may have some allowance to maintain exceptional policy accommodation as the dangers of dropping the baton on a robust recovery override the risks of inflation usurping the economic agenda.

Growing Out of Risks
In fact, given that the nature of reflation cost-push tends to be destructive for demand recovery (through erosion of profits and discretionary income), a combination of fiscal stimulus to “crowd in” private sector investments alongside monetary accommodation may be one path to lift growth/production capacity and technological efficiencies to grow out of debt as well as supply-side cost-push risks more durably.

All said, prioritizing the risks that the global economy is confronted with, we may not only draw some comfort that inflation risks are kept at bay by negative output gaps but in fact that negative output gaps demand that central banks and governments don’t take their foot off the pedal.