Since this post just a couple of months ago, the macroeconomic picture has changed. At the time of that post, the concern was that inflation was still high. Macrosight explained the main reason behind that persistence: the output gap was, and had been, persistently positive. Now, two months on, the very latest estimate from Macrosight’s favorite GDP projection-source, the Atlanta Fed’s Nowcast, has GDP falling by 2.8 percent in the first quarter of this year.
Let’s take yet another look at the output gap to see what this means for the macroeconomy, specifically with respect to the rate of inflation.
A Negative Output Gap
The output gap is a representation the business cycle, showing how real GDP revolves around the long run average (discussed in detail by Macrosight here); the Output Gap is defined as follows:
Output Gap = Current rate of real GDP – Long run average
Visually, the output gap looks like this:
To have a negative output gap implies that the current rate of real GDP growth is less than the long-run average.1 The current, best estimate of the “long run average” is the Fed’s estimate of 1.8 percent (per the Fed’s forecasts, explained here).2
Table 1 displays the values of the output gap since 2023:
Recall, too, with respect to inflation the following rule-of-thumb applies:
When the output gap is positive, the rate of inflation increases.
When the output gap is negative, the rate of inflation decreases.
How do make use of this rule-of-thumb to understand inflation?
Predicted Inflation and the Output Gap
Like we did in the post from two months ago, we can use the information on the output gap to predict inflation (see that post for all the various assumptions underlying this exercise). Table 2 displays the updated information.
The prediction exercise anticipates a notable decline in the rate of inflation—down to zero, in fact.
Will it actually be zero by the end of this quarter? Probably not. Inflation is much more slow-moving or “sticky” than that (as discussed in multiple posts by Macrosight).3
But, as real GDP growth sinks, so too should inflation, all else equal.
And that, dear Macrosight readers, implies a couple of related possibilities:
If inflation declines, so too should long-term interest rates—such as the mortgage rate. The rate of inflation’s stubborn persistence over the last five months is an important factor explaining why the mortgage rate has not declined much over that time span (in spite of the Fed’s rate-cutting, discussed here). Negative GDP growth may be the thing that finally brings inflation back closer to 2 percent.
As real GDP growth declines and inflation declines, the Fed will be much more likely to lower rates. Whether or not that will happen at their next meeting—which is next week—remains to be seen, of course. But, with the unemployment rate ticking up in February and the anticipation of negative economic consequences of the escalating tariff war would suggest the Fed is thinking that way.4
Of course, other possibilities are in play. The aforementioned tariff war implies that inflation will increase—in so far as the tariffs effect enough of the goods and services measured in the CPI or the PCEPI price index. And, if the Fed gets really spooked at the prospect of declining GDP growth and the potential for a recession, they may become aggressive with rate cuts. If those rate cuts help push the output gap back to a positive value. In that case . . . well, refer to the rule-of-thumb above.5
We can have a positive real GDP growth rate and still have a negative output gap. Notice in Table 1, for example, the data for 2024 Q1.
In the post “The 30,000 foot view,” Macrosight explained the output gap in terms of the difference between potential GDP and real GDP—so, in terms of dollars. Here we are looking at the gap in terms of percent. One can do either. In practice, most macroeconomists would focus on percent. When I teach introductory macroeconomics I start with explaining the output gap in terms of dollars. That, based on my experience, is more intuitive for students to understand at first. That is why the image of the output gap in this post shows an upward sloping “long-run average”—since I always draw that picture with dollars on the vertical axis (though that is not shown explicitly on the figure in this post). However, in terms of percent, technically the “long-run average” would be a flat line, reflecting a constant 1.8 percent over time (or some other number depending on the time period you have in mind). These ideas are also discussed in other Macrosight posts here (“Anatomy of the Business Cycle”) and here (“Where are we?”).
Note also that in the calculation underlying the numbers in Table 2, I assume a one-for-one relationship with the output gap and inflation. In terms of the equation shown in this post and originally explained in this post, that means the “turtle” equals 1. In reality, the relationship is not likely to be one-to-one. It is probably less than one, in fact. I assume a value of one to keep it simple.
On the other hand, the current prediction from the Federal Funds Futures market is that the Fed will stand pat with its interest rate target. The current probability of the FOMC sticking with its current target of 4.25-4.5 percent is 99 percent. At least that is the case as of this writing on 3/12. A lot could change between now and when you read this, of course.
Let me also add that with respect to the Atlanta Fed’s current Nowcast estimate of -2.8 percent, I think such a begin decline is unlikely. I say so because out of 311 quarterly changes since the beginning of 1947, there have only been 44 quarters with a negative real GDP growth rate. That is, only 14 percent of the time have we had quarters with negative real GDP growth. In addition, only six percent of the time (or 19 quarters out of 311) have we experienced a negative growth rate of -2.8 or more. Macrosight discussed the distribution of real GDP growth in this post (“Was 2021 a “Career Year” for the U.S. Economy?”). So, it could happen, but it’s unlikely given our history. However, given this context, should the Nowcast prediction bear out, it will represent an unusual GDP event and we can all raise our level of concern accordingly.