By the time the insurrections start, the end is near

Real GDP relative to Potential GDP (quarterly data):

Like the Second Graph from the 25th, but in Excel and with a Hodrick-Prescott Added

The differences between Real and Potential GDP are small: Generally 4% of Potential or less. Thus the blue line is mostly between 0.96 and 1.04. But this ignores the obvious downtrend which tells us things are getting worse.

Before the mid-1970s the blue line spent a lot of time above the 1.02 level and very little time below the 0.98 level. Thus in the early years the trend lines are high.

Since the mid-1970s, blue has spent very little time above 1.02. And the time spent below 0.98 is longer -- the "V"-shaped lows are wider at the 0.98 level than they are in the early years -- and the lows are frequently lower than in the early years. Thus in the middle and later years, the trend lines are lower.

Since I had the spreadsheet open, I started counting "good" and "bad" economic performance. I used the same measure I used above: two percent or more above Potential is "good" performance; two percent or more below Potential is "bad".

The counts of mid-range performance (within ±2% of Potential) were high in all three time periods, ranging from 48 to 70. It's the data to the left and right on the graph, the low performance and high performance data counts, that really shows what happened.

Looking at "high" performance, on the right, it turns out that 1949-1973 has almost as many quarters of high performance as it has "mid-range" performance. The 1974-1994 period had one single quarter of high performance. The 1995-2019 period had two, and that's it.

The rest of the data is on the left, shown by the "low" performance bars. High numbers for 1974-1994 and 1995-2019, both. A low number for the early years, 1949-1973.

Don't be deceived by the mid-range bars. All three time periods have high counts of mid-range performance. But look what happened with the high and low performance data: For the 1949-1973 period it was mostly high performance. For the other periods, almost everything was low performance. Mid-range and high for 1949-1973; mid-range and low after 1973. That's the difference.

In The Causes of Inflation Frederic S. Mishkin wrote:

... demand-pull inflation will be associated with periods when output is  above the natural rate level, while cost-push inflation is associated with periods when output is below the  natural rate level. It would then be quite easy to distinguish which type of inflation is occurring-if  we knew what the value of the natural rate of unemployment or output is. Unfortunately, the economics profession has not been able to ascertain the value of the natural rate of unemployment or output with a high degree of confidence.

Mishkin says it would be easy to tell whether inflation was cost-push or demand-pull if we could trust the numbers we have for Potential GDP. But we can't trust that data, he says. Maybe so, but that doesn't stop the Fed from relying on Potential GDP when they use the Taylor rule or when they make policy decisions based on the Phillips curve and stuff like that.

Real GDP is in decline relative to Potential GDP, and it looks like the decline has been persistent and deepening since 1949. That doesn't look random to me. Nor does it look like a whole series of estimation errors. I think Potential GDP data is fairly trustworthy. And I think Real GDP persistently below Potential is telling us something we'd rather not know.

Real GDP is in long-term decline relative to Potential GDP. On top of that, if you go back to the first graph in yesterday's post, Potential GDP is also in long-term decline. So GDP is declining relative to something that is in decline, and this "something" just happens to be our best estimate of best-case GDP. 

Conclusion: GDP is in a troubling decline. Gradual, yes, but troubling. And GDP is largely below Potential, meaning we should expect inflation to be cost-push inflation. So we have a cost pressure problem that contributes to further decline.

Now let me remind you what I've been writing about lately in my "Terms of the Times" series: cost pressure, which is usually called cost-push inflation because of the effect it has on the price level. But I've also been saying that the problem with cost pressure is not so much the inflation as it is economic decline. Cost pressure creates economic decline. You saw the graphs, right? Something is driving GDP growth down.

Mishkin says cost-push inflation is associated with periods when Real GDP is below Potential. The trend lines say Real GDP has been below Potential since the mid-70s. Mishkin might not want to bet on it, but maybe all the inflation we had for the last 45 years was cost-push inflation and it has been slowing the economy for 45 years. This is the warning that emerges from Mishkin's observation.

As I would say it, cost pressure creates economic decline unless the pressure is fully relieved by inflation, probably on purpose, by policy. As economists and their diagrams say it, cost pressure creates economic decline anyway, whether or not the pressure is relieved by inflation.

The only people who don't say cost pressure creates economic decline are the people who get fired-up when they hear the syllables "cost-push" and immediately get loud and vocal on the problem of inflation. But that doesn't mean there's no economic decline. It means they overlook the decline that cost-push creates because they got fired-up before they thought the problem through to the end. And, unfortunately, the harder you fight inflation the greater the economic decline you get from the cost pressure, because the pressure isn't getting relieved by inflation.

I'll say this one more time and then I'm gonna go take a nap. If cost pressure exists, GDP growth is in decline for sure. And if you restrain the inflation at all, and maybe even if you don't, the decline deepens.

The solution, however, is *NOT* to accept inflation as the "least worst" option.

The solution is to figure out the source of the cost pressure -- HINT: the excessive cost of excessive finance -- and reduce that cost. Now you might think, as I think, that the Federal Reserve tried to reduce the cost of finance in 2008 by reducing interest rates to absolute zero. But the low rates only had immediate impact on *NEW* borrowing, and there was plenty of old, existing debt, plenty of it, enough that finance was still excessively costly. And it still is.

The Fed still hasn't done anything to relieve that problem. Nor has Congress. So the cost pressure remains. Economic decline continues. And we still have inflation.