Globalisation means the US output gap is no longer such a useful input into the Fed's monetary policy framework. A new report by HSBC economist Janet Henry, Gap-ology and globalisation: Measuring the global output gap (PDF), looks at the global output gap and the implications for US inflation as it closes. Here is the summary:
The last two statements issued after the Fed’s FOMC meetings have talked about “possible increases in resource utilization” and their “potential to add to inflation pressures”. Yet, in recent speeches, one FOMC member has warned that the US output gap – the usual measure used by economists to gauge resource utilisation – is no longer a useful concept for the Fed to consider in setting monetary policy because of the forces of globalisation. In other words, the growth potential of the rest of the world now needs to be considered by the Fed in its policy framework, not just the labour and capital capacity of the US.
Does this mean that the concept of a global output gap could be more useful than the US output gap? Possibly – if we could measure it. Because China, India and much of the developing world are growing so rapidly, their share of global GDP is increasing steadily. But the usual methods of calculating estimates of global trend growth do not reflect this. They suggest that the trend rate of global GDP growth is currently 3.5% and the global output gap turned positive to the tune of about 1% of global GDP in 2005: in other words, the global economy is expanding at a rate that is above its trend or "potential" growth rate. But weighting up regional trend growth estimates for the emerging markets according to their current weights in global GDP suggests global trend growth could actually already be 4% or more. This would mean the global output gap would not turn positive until this year.
We estimate that the output gap of the rest of the world is just as important in explaining US inflation is the US output gap itself. With global economic activity set to move above trend in 2006, this, by itself, would imply higher inflation in the US economy this year than in 2005. However our model can only quantify the demand implications of globalisation on inflation, not the role globalisation plays in exerting downward pressure on western wage growth and inflation expectations.