Policy decisions by the Federal Reserve have always been driven by the balance between inflation and recession risks. The difference this time is the enormous consequences of misjudging that balance. On one side, policymakers face a possible surge in inflation if they withdraw too slowly the massive amount of stimulus they've injected into the economy. On the other, they must ensure the economy will not suffer a relapse, which could push down prices and wages, setting off a pernicious round of deflation.
Economists generally agree that, right now, deflation is still the bigger potential problem. But ever so subtly the balance of risks is beginning to shift away from deflation. That doesn't mean any move to tighten is imminent, as Fed Chairman Ben Bernanke reiterated on Oct. 8. But it does suggest that the end of the greatest monetary stimulus in history has finally appeared on the radar.
With inflation clearly headed down, caution will rule out policy tightening well into 2010. Inflation, using the Federal Reserve's preferred measure, was -0.5% in August, but that decline in prices is not true deflation. The drop is the result solely of lower gasoline prices. Still, core inflation, which excludes energy and food, has fallen to 1.3%, down from 2.7% this time last year. And because inflation typically continues to decline for at least a year into a recovery, the rate may even breach the lower end of the Fed's 1% to 2% comfort zone next year.
Deflation is a concern because of the unusually large amount of unused labor and production capacity created by the deepest recession since the 1930s. That slack erodes pricing power and the ability of workers to command higher wages. By some estimates, real gross domestic product is now some 6% below where it could be if all workers and production facilities were fully utilized.
The recovery is starting to reverse some of these deflationary forces, including many of the excesses that have contributed to the downward pressure on inflation. Now that policymakers have stabilized the financial markets and demand, many businesses find that they have cut inventories, capital spending, and payrolls too deeply. They face inadequate stockpiles and the need to boost output and payrolls to meet even a modest pickup in demand. These conditions will take up some of the slack in the economy and put a floor under prices and wages.
After slashing inventories by a record amount, businesses are shifting gears to a slower pace of liquidation. That means output is increasing, which will be evident in the report on third-quarter GDP on Oct. 29. More production is putting some of that excess capacity back into use. Factory operating rates, while historically low, turned up in July and August.
Plus, there's less excess capacity to soak up. The volume of equipment and productive facilities has shrunk, especially in manufacturing. Economists at JPMorgan Chase (JPM) estimate that outlays for business equipment and software have been cut so sharply relative to the rate of depreciation that the U.S. capital stock will decline in 2009 for the first time since World War II. This shrinkage may partly reflect the credit boom, which fueled demand and created a lot of production capacity that is now worn out or obsolescent.
Slack in the labor market is sure to take a long time to absorb. Still, the 8 million jobs lost since the end of 2007, including the Labor Dept.'s latest benchmark revisions, have taken payrolls to unsustainably low levels. When demand was falling, businesses could squeeze out huge productivity gains from slimmer payrolls. But with demand now increasing, companies cannot sustain the 6% productivity growth of recent quarters. Soon they will need to add workers.
These emerging trends are still a far cry from those that would be associated with inflation concerns and Fed tightening. But the recovery is slowly creating conditions that will stem deflationary pressures and allow the Fed more leeway to start reversing its actions of the past year.