March 29, 2011
The output gap
One area where Ladd and Everson disagreed most sharply was in regard to the output gap – whether it is considered in terms of industrial capacity utilization or in terms of unemployment – and what impact it will have on inflation forecasts.
Ladd said that labor costs have been severely depressed as corporations have cut costs to push profits higher. But at some point that will stop, he said, and when it does it will lead to wage-based inflation.
Ladd noted that the unemployment rate among college graduates is 5%, yet it is 15% among those who have not finished high school. He expects this disparity to persist because it reflects a structural change in needs across the workforce. He noted that other countries facing similar problems are facing high inflation. In the UK, inflation is 4.4% despite a “huge output gap,” he said.
Everson expects an output gap to remain. She said that manufacturing activities “have been on a tear” for two years globally and deliveries are still not arriving on time, as consistently reported by purchasing managers over that time period. She doesn’t expect projected economic activity will close that gap.
What needs to happen in order to inflation to occur, Everson said, is for there to be a “handoff” to consumer spending. But that handoff won’t happen until labor markets and credit markets are stronger, she said.
Everson spoke at a similar BSAS event in the fall of 2009 and offered the same forecast for low inflation – a forecast which so far has proven to be completely accurate.
At the time, she recommended increased allocations to equities. This time, while acknowledging that the stress in Japan presents near-term challenges for stocks, she said, “we are in one of the most powerful bull markets any of us have seen. Using equities is recommendation number one.”
She went on to say that investors should not be afraid of bonds. She said we will have rising bond yields “only to the limit of what the economy can tolerate, and it is proving to be not that much yet. It has been four years since the start of the crisis, and this is still the advice we give you.”
The US dollar will be a “little stronger” than when QE1 began, she said, and low yields will ensure there will not be much room for change in either direction.
Lastly, Everson warned that investors should look out for surprises, “because with this much intervention there is surely going to be one.”
Ladd’s investment advice was a lot less specific than Everson’s. “If you really believe that inflation is a longer-term issue, don't wait until it becomes vastly more important,” he said. “It is going to have profound implications long before tactical investors will be able to react.”
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