The credit crunch is easing. The economy is giving off some encouraging signs that it's beginning to stabilize after 17 months of recession, and more forecasters now expect a return to at least modest growth during the second half of the year. All this is starting to fuel questions about the timing of the Federal Reserve's endgame for monetary policy. After all, the Fed always acts preemptively as a recovery takes hold to assure inflation stays down, which is a particular concern this time, given the flood of funds the central bank has pumped into the system. Trading in the futures market already shows investors are betting the Fed will begin to lift its target interest rate within the coming year.
That's probably a bad bet—even given the inflation potential in the Fed's actions. Over the long run, inflation is always caused by too much money in the system. But under the current strained financial conditions, the Fed's prodigious provision of funds is not expanding the money supply as it usually would. The explosive potential for the future is clearly there, but right now each dollar the Fed puts into the economy is yielding only about half the typical impact. More important, the Fed will have plenty of time to drain away this excess before inflation becomes a problem.
Why? High unemployment and a record amount of idle production capacity will exert downward pressure on wages and prices for a long time. Last quarter, pay and benefits over the past year grew only 2%, down from 3.1% a year earlier and marking a record low. The comparable annual rate over the last two quarters was only 1.3%. Yearly core inflation for consumer prices, omitting the fluctuations in energy and food, was 1.9% in April, down from 2.3% a year ago. Excluding a 29% surge in tobacco prices due to higher excise taxes, core inflation over the past six months is running at 1.3%.
Current downward forces will remain in place not for months but years. It will take that long for markets and distribution channels to tighten up to the point where workers and production capacity become scarce enough to reverse the downdrafts on wages and prices. This slack is striking when viewed as the difference between real gross domestic product and what economists call potential GDP, or the level of GDP the economy could produce if all available workers and production capacity were fully utilized. Using the Congressional Budget Office's estimate of potential GDP, actual GDP is on a path to end 2009 some 8% below its full capability.
Potential GDP, which is based on the long-run growth trends in productivity and the labor force, is growing about 2.3% per year. So the economy has to expand faster than that just to start narrowing the gap. Even if GDP growth hits the optimistic end of the Fed's latest forecast range, the economy would still be nowhere near closing the gap by the end of 2011. To absorb all its excess labor and capacity by then—and begin to generate pricing pressures—the economy would have to grow 4.4% per year starting now.
This gap is the chief reason why inflation always lags behind turns in the business cycle. Core consumer inflation continued to fall for about two years after the end of each of the last two recessions. This time the downward push on wages and prices is even greater. After the 2001 slump, which was accompanied by worries about deflation, the Fed did not begin to lift its target rate until 2 1/2 years after the recession ended. After the 1990-91 downturn, the first rate hike didn't come for nearly three years.
Both Fed Chairman Ben Bernanke and Treasury Secretary Timothy Geithner have noted that a crucial policy error during the financial crises in the U.S. in the 1930s and in Japan in the 1990s was the eagerness to tighten policy before a recovery was firmly established. The result in both cases was a return to recession. That's a mistake policymakers are unlikely to make this time, especially with inflation pressures so heavily under wraps.