Inflation-devouring output gaps immense worldwide

If inflation is coming it is going to have to overcome one yawning gulf in the global output gap. The US has the best chance. Goldman with the note:

Exhibit 5 presents our long-run output gaps for the US, Euro Area, Japan and UK. The appendix shows our country-by-country output gap and NAIRU estimates compared to official institutions. We estimate that the G4 economies have spent much of the past decade below potential, with the UK just about reaching potential before the pandemic while GDP in Japan (-½%), the US (-1%), and the Euro Area (-1½%) all remained somewhat below potential. However, there is now much more long-run spare capacity in 2021Q1 in the Euro Area (-8%) and especially the UK (-9½%) than in Japan (-4½%) and the US (-4%) as a result of larger falls in GDP last year in Europe.

Our Euro Area estimate of around -8% in 2021Q1 masks large differences across member states as deeper pandemic recessions in Southern Europe have widened the pre-pandemic gap with Germany further. Specifically, we estimate output gaps in2021Q1 of around –5½% in Germany, -7% in France, -10½% in Italy and as much as-12½% in Spain.

Exhibit 7 compares our 2021Q1 long-run output gap estimates to those from official institutions. We generally see more spare capacity than the official institutions as a result of larger output gaps in 2019Q4 and less net scarring during the pandemic. Specifically, our long-run output gaps are significantly larger than institutional estimates in Europe, especially in the UK and Italy, where they are roughly 4½pp larger, and France and Spain, where they are roughly 3½pp larger, but also in the US and Canada (2pplarger), and Japan (1½pp larger). Our output gap estimates are generally less large, both relative to other economies and to official institutions, in the small open G10 economies, especially New Zealand and Sweden.

Finally, Exhibit 8 shows our forecasts for the output gaps through the end of next year for the US, the Euro Area, the UK, and Canada by combining our 2021Q1 long-run output gap estimates with our above consensus growth forecasts. We expect long-run output gaps in 2022Q4 that are moderately positive in the US (+1½%), roughly zero in Canada, slightly negative in the UK, and moderately negative in the Euro Area (-1½%).

The risks to our estimates of the output gap—which are unusually uncertain because they rely on GDP data during the pandemic—are two-sided. On the one hand, resilient wage growth(Exhibit 9, left), and the risks of more persistent pandemic bottlenecks or more substantial scarring suggest that we might be overestimating spare capacity.

On the other hand, the still low employment levels in North America, and potentially larger pandemic productivity gains suggest that we might be underestimating spare capacity. The right panel of Exhibit 9 compares our GS 2021Q1 long-run output gap estimates to those implied by the 2021Q1 unemployment rate using Okun’s law (the relationship between the unemployment rate and output gaps). In the US and Canada, where furlough schemes were absent/relatively limited, output gaps implied by the unemployment rate are about 1/2 pp larger than our new estimates, while they are much smaller in Europe and Japan because of the limited uptick in unemployment under furlough schemes.

Although we expect the US to move modestly above potential in 2022, the output and inflation overshoot should be relatively limited and so we do not expect lift-off until 2024under the Fed’s dovish new framework. We believe extra slack, combined with sequencing constraints in the UK, will keep the ECB and BoE on hold until 2025. Out of the major G10 economies, we expect the BoCto lift off first, in late 2022, under a speedy return to potential.

David Llewellyn-Smith
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