Inflation -- Long Term

To study long term inflation potential, I derive a base inflation
rate by taking the 10 yr. growth rate of money M2 minus my
estimate of economic growth potential. Inflation potential did rise
over the past 10 - 15 yrs to roughly 3.5% per annum on a moderate
acceleration of money growth and a reduction in economic growth
potential, with the latter reflecting a slowing in the growth of the
labor force.

Inflation averaged about 2.6% over the past 10 yrs. compared to
inflation potential of 3.5%. The shortfall obviously reflects bookend
recessions, which impaired demand growth. But it also reflects a long
term downtrend in the rate of capacity utilization. In fact, the last
times the economy operated at effective full capacity was in the 1994-
98 interval. With low output growth over 1999 - 2009 also came a
substantial increase in the trade deficit reflecting in significant part an
influx of lower priced goods from abroad. This development coupled
with a sharp net increase in the off-shoring of jobs contributed to
lower labor costs. Even commodities prices, which did put upward
pressure on the inflation rate after 2002, collapsed over the back half
of 2008 before commencing to recover.

We start the new decade with very large excess slack in the US
economy and globally as well. Inflation potential over the next several
years will remain around 3.5%, but to sustain that kind of elevated
level will require a substantial increase of operating rates and
enough of a recovery in the labor market that workers can begin
demanding and getting stronger wage gains. Upward pressure on the
inflation rate from the occasional flare up of commodities prices is not
likely to prove sustainable without significantly higher levels of
facility and labor utilization.