MNI INTERVIEW: Inflation To Slide If Output Gap Closes-Gagnon

Inflation in the UK and elsewhere could fall swiftly if output drops back below potential, former Federal Reserve official Joseph Gagnon told MNI, after his research featured in a Bank of England run-down of a debate over the future path of inflation.

In a recent presentation, BOE economist Galina Potjagailo pointed to work by groups including Gagnon and his co-author co-author Kristin Forbes, a former BOE Monetary Policy Committee member, as representative of one of two broad academic camps on the future of inflation, given the failure of mainstream central bank models to predict the current upsurge in price increases. Gagnon and Forbes argue that prices can respond swiftly to moves in the output gap, in contrast to the view taken in research by the Bank for International Settlements and others, who think the world may have moved into a higher inflation regime.

Gagnon, now a senior fellow at the Peterson Institute, said that whilst he accepted the contention by BIS researchers including Claudio Borio that the world can switch between periods dominated by self-reinforcing tendencies to high or low inflation, the last shift in U.S. inflation regimes "took five-to-10 years to kick-in,” whereas the post-Covid environment of rapidly-rising prices is still young.

"We aren't in that regime-shifting world yet," Gagnon said.

HOCKEY STICK PHILLIPS CURVE

For the moment at the BOE, the majority on the MPC place more weight on asymmetric inflation risks, with the fall markedly slower than the rise, tending to argue for further policy tightening. Still, Gagnon said his work, which identifies a non-linear, “hockey stick” Phillips Curve, where inflation can respond swiftly to moves in the output gap, had been accurately characterised in Potjagailo’s presentation at an ESCoE conference last month. (See MNI: Covid Revives Phillips Curve-Former Fed, BOE Officials)

"It is a fair reading of our research that inflation would fall quickly if output returns to or below potential. This reflects the strongly-anchored expectations of inflation we see in surveys and bond markets. We believe it is the longer-term expectations that are relevant, not the 12-month ahead measures, which mainly move contemporaneously with actual inflation and don't work well in wage- and price-setting equations," he said.

Gagnon is currently working on sectoral supply curves, with the extraordinary demand rotation from services-to-goods during the Covid pandemic driving up inflation while opening the door to strong deflationary effects if and when it fully reverses.

The shift in demand across sectors "is inflationary even if aggregate demand is unchanged, whenever you start at potential in all sectors. That is because there is rapidly rising inflation in the strengthening sectors with little offsetting disinflation in the weakening sector," he said.

"The magnitude of the switch of consumption from services to goods in 2021-22 was unprecedented in the postwar era, as was the swing from deflation to inflation in goods. The switch back should be deflationary, and I am surprised it hasn't happened much yet, but I still hold out hope," he said.

While services prices can be sticky on the downside, because of the difficulty of cutting wages which make up much of their cost, the same does not hold for goods, Gagnon said.

"There is room for return of durable goods prices to previous trends .. you could see outright deflation in those goods prices," he added.