Given all the monetary fuel sloshing around the economy right now, it's easy for investors to feel a little edgy about future inflation. So policymakers at the Federal Reserve have gone to great lengths to convince people the Fed has the tools to sop up the excess funds before they ignite an explosion in prices. However, market professionals have never doubted the Fed's ample assortment of tools. The question has always been about timing. Too little policy tightening too late could kindle inflation, forcing more stringent measures to tamp it down later on.
Following their Aug. 11-12 meeting, Fed policymakers sounded a pinch more optimistic than they did after their June meeting. Indeed, fresh news from the July labor markets amid other favorable signs suggests the recession is all but over. Still, the central bankers said they will keep interest rates exceptionally low for a long time. Inflation? Not to worry, they say.
Fed officials seem confident that economic conditions will offer an unusually wide time frame to begin tightening policy before price pressures can build. The reason is the enormous slack, or unused labor and production capacity, created by the deepest recession since the 1930s, and the long time that will be needed to absorb the excess. U.S. industry was operating at only 68% of its capacity in June, a record low. History, and basic economics, show inflation cannot take hold until resources start to get stretched.
The most compelling anti-inflation story comes from the labor markets. Any broad and sustained speedup in prices would require a reacceleration in wage growth, the classic wage-price spiral. However, despite the encouraging news from the July job data, including a smaller-than-expected 247,000 drop in payrolls and a dip in the jobless rate to 9.4% from 9.5% in June, it will be a long time before the job markets are strong enough to push up hourly wages.
Right now, the spiral for both wage and price inflation is downward, and the rates for both are set to fall further. Hourly wages of production workers last month rose only 2.5% from a year ago, down from a 4.2% pace before the recession began. The comparable annual rate in recent months has been even weaker. At the same time, core inflation, which excludes the short-term ups and downs in energy and food, has fallen more than a percentage point over the past year, to 1.5% in June. Many economists believe the rate will head toward zero in coming months, a pace below the Fed's comfort zone and dangerously close to deflation, or falling prices.
Wage growth is sure to slow further, since few economists believe the jobless rate has topped out. That won't happen until the economy is strong enough to create the 100,000 or so jobs per month that are necessary to keep the jobless rate from rising. Even after unemployment peaks, it will be far above 5%, thought to be about "full employment." That's the level where price pressures intensify—a mark unlikely to be reached during 2010.
In addition, businesses will be hesitant to rehire laid-off workers until they absolutely have to do so. Companies are enjoying the cost advantages of their slimmed-down workforces. Productivity, or output per hour worked, surged at a 6.4% annual rate in the second quarter. With real gross domestic product widely expected to grow 2% to 3% in the current quarter as hours worked continue to fall, productivity is set to post another solid advance this quarter.
Big productivity gains, along with weakening wage growth, mean unit labor costs, or pay adjusted for productivity, are plummeting. These costs, which are closely aligned with the pressure to raise prices, fell at an eye-popping 5.8% annual rate in the second quarter after dropping 2.7% in the first quarter, and they most likely will fall again in the current quarter.
The Fed will be especially vigilant to ensure that its flood of funds does not lift expectations of inflation that could influence price markups and wage setting. But until labor markets improve significantly, any such expectations are highly unlikely to take hold.