When it comes to a key monetary policy issue — the amount of "slack" in the economy — opinions vary widely among Fed policymakers, but Atlanta Federal Reserve Bank President Dennis Lockhart has it about right with his belief that resource slack is neither as great as some contend or as small as others maintain, according to an aide.

Michael Bryan, vice president and senior economist for the Atlanta Fed says the evidence supports what Lockhart has called his position in the "gray middle" on the amount of slack.

Macroeconomists and Fed officials are more inclined to talk about the size of the "output gap" -- the difference between actual and potential GDP growth -- than about slack. Either way, a debate has been raging for months on the Fed's policymaking Federal Open Market Committee about how big the gap, or the slack, really is.

It's not an inconsequential issue.

Those, such as Fed Vice Chairman Janet Yellen, who think the gap is large, that there are a lot of unused or under used labor and other resources, are inclined to think there is ample room for monetary policy to stimulate demand and reduce unemployment without fear of engendering inflation pressures.

Those, such as Richmond Fed President Jeffrey Lacker, who think various "structural" factors have narrowed the effective output gap, are inclined to think the Fed has less room to safely inject additional stimulus.

As Bryan writes on the Atlanta Fed's "macroblog" after quoting Yellen and Lacker, "The positions outlined above lay bare why estimates of the output gap command such weight in the discussion of monetary policy -- both ends of the FOMC's dual mandate of maximum employment and price stability may run through it."

"If the output gap is large, that is, if the level of gross domestic product (GDP) is running significantly under potential GDP, the economy is obviously not in a position of maximum employment," he says. "And if that is the case, the inflation trend is likely to be headed lower and so the price stability mandate may also be in jeopardy."

Lacker has said he thinks labor market inefficiencies, extended unemployment insurance and the like "account for a quite substantial portion of our elevated unemployment rate."

Yellen, on the other hand, has asserted that "the bulk of the rise (in unemployment) during the recession was cyclical, not structural in nature."

Lockhart, an FOMC voter, takes a middle position.

"I think the output gap -- the amount of slack in the economy --is neither as sizeable as the high-end estimates, nor is it zero," Lockhart said in a recent speech in Jackson, Miss.

"If there were no slack at all, 8.2% unemployment would represent full employment," he continued. "If this were so, the economy would have undergone profound structural change over the last five years. As I weigh the findings of research by Federal Reserve economists and others, I do not think a compelling case has yet been made that structural adjustment has played a dominant role in slowing growth and progress against unemployment."

"If, on the other hand, slack in the economy were close to the high estimates, we should have seen more and more persistent downward pressure on prices and wages than has, in fact, been the case," Lockhart went on. "Deciding on the extent of the output gap is not straightforward. I believe the truth is in the gray middle."

Bryan defends Lockhart's position.

"To emphasize, this 'gray middle' isn't a compromise but a weighing of the available evidence," he writes. "If the GDP gap really is close to zero, the profound structural change that the economy ought to have experienced hasn't found great support in the data."

"But if this is just a bigger version of gaps of recessions past, then where is the great disinflationary pressure such slack would ordinarily imply?" Bryan asks.

The size of the output gap almost certainly is up for discussion again at this week's FOMC meeting.

Market News International is a real-time global news service for fixed-income and foreign exchange market professionals. See www.marketnews.com.

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