The decision of central banks to focus more on economic slack as a barometer of when inflation will become a problem could backfire, if history is any guide.
The Federal Reserve, Bank of England and European Central Bank have started using the level of spare capacity in their economies as a way to foretell when they will start reversing easy monetary policies.
The more capacity, the bigger the output gap between actual and potential economic growth and the longer officials can keep interest rates low because price pressures will be sluggish.
"While this sounds plausible, past experience suggests that central banks tend to hike rates too slowly, with corresponding risks for price inflation," Christoph Balz and Bernd Weidensteiner, economists at Commerzbank AG in Frankfurt, said in a March 21 report.
The problem is that output gaps are hard to estimate and better done in hindsight.
To demonstrate that, the Commerzbank economists looked at what the Fed would have estimated for the output gap in the early 1970s, given the data they had available from the prior three decades.
The initial impression was of an output gap of minus 1 percent for 1974, which would have encouraged the U.S. central bank to be "moderately expansionary," said Balz and Weidensteiner.
In reality, the economy was later shown to have been slightly over-stretched in 1974.
Repeating the exercise for 1983, the output gap the Fed would have calculated at the time was minus 1 percent, versus the minus 4 percent it proved to be.
"In other words, a more restrictive policy would have been appropriate in 1974, but in 1983 a more expansionary policy was required," said Commerzbank. "This demonstrates the uncertainty prevailing when monetary policy conclusions are drawn from the current data set."
With the Fed's new lines of communication aimed at damping expectations of rate hikes, the risk is the Fed "will again probably raise rates too late and too cautiously," said the economists. This time the "greater danger" may be that loose monetary policy fans inflation in asset prices.
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Sovereign ratings are often out of kilter with economic fundamentals, undermining the ability of ratings companies to monitor the $50 trillion of outstanding public debt, according to UniCredit SpA.
In a study of the ratings of Moody's Investors Service, Standard & Poor's and Fitch Ratings, UniCredit economists led by Erik F. Nielsen said economies in Europe's so-called periphery, such as Portugal and Spain, are rated on average five levels below what their economic performances suggest.
Brazil, India, Indonesia, Turkey and South Africa — the so-called fragile five emerging markets — are rated on average almost two levels higher then the underlying economic conditions imply.
"History is littered with countries being over- and under- rated by the ratings agencies with — at times — dramatic consequences," Nielsen and colleagues wrote in the March 26 report.
The economists suggested credit rating companies be forced to increase transparency and better explain their decisions.
The global financial crisis may not have killed off the Great Moderation.
From 1984 to 2007, volatility in consumption, investment and economic growth fell across the developed world, leading to suggestions that boom-bust cycles were a thing of the past, Goldman Sachs Group Inc. economists Charlie Himmelberg and Julian Richers said in a March 26 report.
The crisis and subsequent global recession upended that theory, but the Goldman economists suggest the world has perhaps already returned to calmer times.
They note that swings in U.S. private-sector employment growth over the past three years are already at their lowest in more than 50 years.
Economies also are showing signs of shifting toward less-cyclical sectors, such as services, and away from manufacturing.
"We suspect that, more likely than not, the Great Moderation is back," said Himmelberg and Richers, adding that clampdowns by regulators may reduce access to the credit that can drive volatility.
The environment should support more risky investments, especially in corporate debt and equities, the economists said.
