Will there be inflation in the next recession?
As I showed over the weekend, the jumps in inflation during the 1970’s were due to real GDP reaching the Long-run aggregate supply curve (LRAS). But underlying the inflation of the 1970’s were dynamics of growth, optimism, speculation, small business development, union bargaining power and a surging labor force from desirous baby-boomers coming of age as pointed out by Steve Randy Waldman. (Desirous is my painting stroke.)
So when real GDP hit the LRAS zones in the 1970’s, inflation resulted. Inflation rose to over 11% in both recessions. The LRAS zone is marked by the paths of real GDP and effective demand. Where the paths cross (see dashed black lines), the LRAS zone begins. Here are the graphs that I made for the 1970’s… (2009 dollars)
So it is more than obvious that the inflation jumps were created in the LRAS zones as the economy went into recession during the 1970’s. But there were forces to produce inflation. Even though the Fed rate was balanced to bring inflation down to 3% during the 1970’s, inflation moved from 3% before the 1973 recession, rose to 11% during that recession, fell to 6% after that recession and then rose again to 13% during the 1980 recession.
In spite of correct Federal Reserve policy, the financial sector kept feeding the economy and creating money even at higher interest rates. The mood of growth and optimism emanating from the baby-boomers kept the money supply growing in spite of higher interest rates. A higher Fed rate did not matter so much in that atmosphere of growth and decadence in the 1970’s. In essence, society did not respect the intent of the Fed rate to control the economy. They borrowed and the banks lent money. Money was created in spite of a higher Fed rate.
What happened during the 2008 crisis? (This graph puts real GDP in 2005 dollars)
We saw no inflation result as real GDP reached the effective demand limit. The factors underlying a strong inflation were not there as they were in the 1970’s. There is more debt overhang now. Net worth took a hit as the bubble popped. The baby-boomers are leaving the labor force to some extent, or are keeping jobs that could make room for younger workers. Also, there isn’t the mood for growth in spite of interest rates.
What about the next recession? (2009 dollars)
We see the same typical pattern before a recession. Real GDP is trending horizontal at a low inflation rate, while effective demand trends toward the meeting place with real GDP. Where they will meet establishes the LRAS zone. What will inflation do as real GDP enters the LRAS zone? Are there dynamics to support a big rise in inflation? I do not see those dynamics. More baby-boomers will leave the labor force. There may even be a bubble popped to bring down net worth. Debt overhang will still be there. Labor has no power to ask for higher wages.
Will we have deflation? Most likely we will see an effort by inflation to rise, but if there is a bubble popping sound, inflation will back off. Pretty much as we saw in 2008. Deflation may be stronger in the next recession.
Will the next recession be dramatic? Oh yes… there will be labor issues, student default issues, government debt issues, deflation issues, derivatives issues, emerging market issues, on-going QE issues and more.
So say we’re slated to hit the ED curve at $16.1 trillion real GDP. That’s 2.5% above Q2/13, suggesting about a year from now?
I think you’ve probably written about this (link?): in these graphs, theory for why RGDP is always on the AS curve, or defines its X-axis position?
How do you factor in Nixon’s imposing wage and price controls on the entire economy in August 1971 while pressuring Arthur Burns to inflate the money supply which he did, among other measures, to ensure his re-election in 1972? wasn’t that the major factor in causing the accelerating inflation? Also, at that time unions had power which they do not today. Don’t these factors explain a good part of the “stagflation” not seen before or after?
Steve,
Yes, that is the pattern, about a year from now real GDP will enter the LRAS zone.
Real GDP is on the AS (aggregate supply) curve because the curve is determined by an equation with real GDP as an explanatory variable. The equation for the effective demand curve also uses real GDP as an explanatory variable.
Here is a link to the equations (see bottom of post)
http://effectivedemand.typepad.com/ed/2013/04/the-as-ed-model-unit-labor-cost-adjustments.html
Dryly41,
There was no rise in inflation during 1972. Inflation didn’t start rising until 2nd half of 1973.
Here is my thought… macroeconomics has different levels of being macro. Some levels are micro levels of macro. But in the case of the effective demand limit, itsThe over-riding impact is a super macro effect.
In the business cycle, you have your expansion phase. Real output is increasing. You do not see inflation because increasing money is consumed by real output growth. But when real GDP reaches the LRAS zone as determined by the effective demand limit, not by the CBO potential real GDP, real output slows down… and increases in money or demand will translate into inflation and not more real output.
From what I see effective demand plays an important role in inflation. The growth of real output is determined by effective demand. What I mean is that effective demand can stop the growth of real output or give it room to grow.
I will not say that inflation is always the result of real GDP hitting the effective demand limit at the LRAS zone. There are other factors which can fuel inflation in the LRAS zone, but I see that most inflation occurs in the LRAS zone.
Look at this graph, and see how inflation tends to rise around recessions. At each of these recessions, real GDP is hitting up against the effective demand limit.
http://research.stlouisfed.org/fredgraph.png?g=mgy
So how do I factor in wage and price controls, and an increase in the money supply? Their effects get absorbed by real output growth until real output growth hits the effective demand limit. So those things you mentioned didn’t have an effect on inflation until real GDP hit the effective demand limit. Then the effects were translated into inflation and not real output growth.
So when Milton Friedman talks about inflation always being a monetary phenomenon, it is just another reason to say that he is over-rated. The inflation in the LRAS zone is not a monetary phenomenon, but a dynamic of the effective demand limit constraining real output. Then the increase in demand is expressed in higher prices, higher wages.
Another way to say this… If you increase the money supply when real GDP is below effective demand and has room to grow, that increase in money will translate into real output growth, not inflation.