Resurgence of Effective Demand
We are seeing a resurgence of effective demand from both long term yields (borrowing costs) and headline inflation falling.
What if 10-year yields fall to 1.6% by 2nd quarter 2015? And what if headline inflation falls to -0.5% by 2nd Q too? (Barclays is predicting negative headline inflation through 2015, Matthew B tweet.) I graph what effective demand would look like keeping other factors constant (labor share, net exports, government expenditures, private investment, Fed rate at ZLB).
This resurgence in effective demand would make the US economy grow faster. Unemployment would come down more. Capacity utilization would go up more. We most likely would see a boost in real wages.
Core inflation can withstand the effects of lower oil prices that give some pricing power to other products and services. This helps the Fed in their desire to raise the Fed rate later this year. Still any setback to effective demand from a rise in the Fed rate looks to be already completely neutralized and more.
Are there dangers in inflating effective demand so much, so quickly? Eventually headline inflation will rise back to normal. Eventually the longer term 10-year rate stabilizes. Put these together at some point in the future, and you reverse the resurgence. Effective demand could normalize back down to around 77% in graph above.
If the utilization of labor and capital grow too much beyond a normalized effective demand level during the temporary resurgence, then I would expect the economy to contract when effective demand normalizes back down. However this temporary resurgence may be the boost that many economists have been hoping for to get the economy back to full-employment.
(Also see the very good post by Jon Hilsenrath today at the WSJ)
Is this a projection of what is called benign deflation.
Am,
Yes, you could say that. The low inflation and low long term rates are “luring” consumers into an ecstatic state. Most economists seem to want economic growth at any social cost… so headline deflation which spurs growth will be welcomed. The stock market is liking it so far.
http://pages.stern.nyu.edu/~ekerschn/pdfs/readingsemk/EMK%20NYU%20S10%20Benign%20Deflation.pdf
In my wanderings about the blogosphere I came across this which is a bit dated but the principles seemed to be explained. Explanations of the social costs to benign deflation are not easy to find. By which I mean, I don’t know what the social costs are.
Thank you for the response. I put up a question on another blog on the possibilities of benign inflation occurring as a result of the oil decline but was ignored. In defence of the blog the possibilities were not so clear as now. It was last month and things are changing rapidly.
Am,
Thank you for that article. It is interesting.
Many economists would be hard-pressed to use the words benign deflation. Yet I see that there will be some advantages. Yet we will read about the huge risks from deflation.
Still, if the deflation is temporary, there will be a short term boost. The problem I see is when the temporary deflation reverts back to the normal core inflation level. That is when we will see some cutbacks.
But your article is interesting when it cited long periods of time with deflation and high growth. We won’t see that this time. The US economy has matured. However, there is a benign aspect to deflation as you point out.
Thx
The deflation is benign because it increases NET EXPORTS. i.e. it is a positive terms of trade shock! Truly people need to just to understand the circular flow of income it needs only arithmetic, seriously.
Reason,
There is more benign-ness with deflation other than its impact on net exports. Prices do drop, and there is a sort of tax rebate to the consumer. They can buy more stuff with their rigid wages.
Many fixed incomers in Japan have been able to maintain spending due to their deflation over the years.
And read the article that Am posted above in the comment. Here is an excerpt from that article.
“The best example of benign deflation in the U.S. occurred between 1869 and 1896, when prices declined at a 2.9% annual pace while real GDP expanded at an impressive rate of 4.6%.”
Think about that… 27 years of benign deflation. The economy was growing in a whole different way back then. And will not grow like that now. But deflation can increase effective demand. The real key is to have productive investment, not just speculative. The key is to make sure that productive capacity is rising, not just production. The problem now is that productive capacity is not rising like it was in the late 1800’s.
Here is an article that gives some perspective.
http://www.ecology.com/2011/09/18/ecological-impact-industrial-revolution/
I’m sorry but this really is shoddy ceterus parabas thinking. The important thing is not whether prices fall, (they might fall because of falling demand, which combines with debt/nominal rigid wages implies more bankrupcies) but whether the money remains circulating within the economy or leaks outside or stops circulating.
And I bet the story the in the 1860-90 period was import replacement.
http://www.nber.org/papers/w4710.pdf
YEP!
A small rule of thumb for you, before you decide that price effects are working, make sure that you have accounted first for income effects.
P.S. Before you call the deflation of the period “benign”, note that the period is also called the “Gilded Age” (i.e. increasing and extreme inequality).
Look,
I really don’t want to pick on you, but look at the company you are keeping. Doesn’t it worry you when you are linking to posts in the WSJ?
The fact is that income flows are what ultimately determines the macro situation. Think about it, increased productivity with flat wages combined with high profits and rising inequality suggests what? That demand for labour is constrained by less than possible growth. It is benign – for monopolists and oligopolists.