Our topic will be the economic term "the inflationary gap." First, we will attempt to unpack this quote from Investopedia:

An inflationary gap measures the difference between the current level of real GDP and the GDP that would exist if an economy was operating at full employment.The current real GDP must be higher than the potential GDP for the gap to be considered inflationary.Policies that reduce an inflationary gap include reductions in government spending, tax increases, bond and securities issues, interest rate increases, and transfer payment reductions.

If we look at a country's potential GDP, it is composed of its labor force, technology, natural resources, goods, and services. For example, a mature country like the USA may have a potential GDP of 2-3%. However, last year we had a real GDP of 5.7% (see chart below). Therefore, a single-digit growth rate with a large GDP of 24.8 trillion dollars is reasonable. However, an emerging economy probably has a much higher growth rate.

Regarding bullet point 2 above: it turns out that an economy can run at a hotter pace than its potential. How is this possible? By lowering interest rates, printing money, wealth creation from a bull stock market, a red-hot housing market, and public psychology, which thinks this new wealth is normal and will last for a long time. All these conditions together lead to a GDP higher than the country's potential (the "inflationary gap)." Does all this sound familiar to you?

Can't we enjoy our new hot economy and call this the "new" new normal? You guessed it: no. Inflation gets hot too. Inflation rhetoric moves from "transitory" to "we must Whip Inflation Now (WIN)* before it derails the economy altogether.

How do we solve the inflationary gap and reduce inflation? The remedy: take away the wealth effect. How is this done? By the exact opposite: raise rates, take out monetary liquidly (Quantitative Tightening), correct the stock market, correct the red-hot housing market, and change the public psychology from bull to bear. Thus, stock market rallies can be seen as a threat to the Fed's fight against inflation. Keep in mind, when the credit cycle tightens by the Fed raising rates and Quantitative tightening, a bear market in stocks, a housing bear market, and consumer confidence turns negative, all taken together historically point to a prolonged deep recession being highly probable. However, we think it will be a shallow recession.

The Fed is looking for equilibrium in our economy (in our GDP). They are not trying to derail our economy. A year with little or no GDP growth will be meaningful in returning to the trend line. Reducing the Fed balance sheet and rising Fed fund rates will continue until our GDP is in-line with our "potential" GDP. We already see inflation indicators coming down, and it probably won't take much more tightening to right the ship. Stay tuned.

Conversely, if they raise rates too much and taper too much, our economy may run below our potential GDP. "Resetting "our GDP or contracting its growth so it can catch up to its longer-term trend line makes sense. Then our GDP should be able to resume its potential growth of around 2.5-3% with moderated inflation. In our opinion, a contraction is not necessarily leading to a severe recession. Therefore, a healthy shallow recession to reset the inflation gap makes perfect sense.

The chart below shows real GDP long-term growth on a year-over-year basis. Obviously, the year-over-year growth this year will not be 5.7%

Real gross domestic product (real GDP) is an inflation-adjusted measure that reflects the value of all goods and services produced by an economy in a given year (expressed in base-year prices) and is often referred to as constant-price inflation-corrected GDP, or constant dollar GDP. Investopedia

Output Gap:

The term output gap refers to the difference between the actual output of an economy and the maximum potential output of an economy expressed as a percentage of gross domestic product (GDP). A country's output gap may be either positive or negative. A negative output gap suggests that actual economic output is below the economy's full capacity for output. In contrast, a positive output suggests an economy outperforming expectations because its actual output is higher than its recognized maximum capacity output. Investopedia

"Real potential GDP is the CBO's estimate of the output the economy would produce with a high rate of use of its capital and labor resources. The data is adjusted to remove the effects of inflation". FRED

*Whip Inflation Now (WIN) was a 1974 attempt to spur a grassroots movement to combat inflation in the U.S., by encouraging personal savings and disciplined spending habits combined with public measures urged by U.S. President Gerald Ford. Whip inflation now-Wikipedia