The Economy: Beware the Bottlenecks

The one nice thing about a devastating recession is that everything's on sale: Whatever you need is readily available in big heaps, and inflation isn't a problem because sellers are eager to dump their excess supplies. That's why it's a little surprising, not to mention worrisome, that scattered shortages have emerged recently in an assortment of items ranging from economy cars and consumer electronics to such oddities as canned pumpkin and lobster bait.

Are these isolated shortages an early warning that there's less slack in the economy than commonly believed? If so, more bottlenecks could form as the economy gains speed and demand grows. And that, in turn, could drive up prices and force the Federal Reserve to raise rates before the recovery ever hits its stride.

Inflation hawks such as James B. Bullard, president of the Federal Reserve Bank of St. Louis, remember the deep recession of 1974-75, when the Fed overestimated the amount of unused productive capacity in the system. As a result of that mistake, the Fed kept monetary policy too easy and wound up with high inflation. Says Bullard: "I don't want to replay the '70s."

STAGFLATION'S SHADOWBullard is in a minority, to be sure. The predominant view among economists, business executives, and supply-chain experts is that shortages are mostly short-term problems that won't harm the overall economy. They say the bigger and scarier risk is deflation: an economic contraction that causes falling prices, more unemployment, and bankruptcies.

Nevertheless, even some economists who worry mostly about sluggish demand and falling prices say it's worth considering the possibility of inflationary glitches in the supply chain. For one thing, the ongoing credit crunch may be having some unexpected consequences. If weakened companies can't raise the funds they need to expand their capacity, they won't be able to respond to increasing demand. That could produce some ugly combination of higher prices and constrained growth—in a word, stagflation.

Factory closings have recently reduced U.S. industrial capacity at the fastest pace since record keeping began in 1967. David Hensley, global economics coordinator for JPMorgan Chase (JPM), calls himself a "big believer" in the danger of deflation but adds: "This is a unique environment with lots of crosscurrents. I don't think we want to be overly wedded to one model" that says deflation is the only risk.

The auto sector would seem to be one that's vulnerable to supply disruptions despite the massive decline in sales. Automakers have decreased their capacity at the most rapid pace since World War II, according to Federal Reserve data. That capacity reduction has helped prop up prices. Surprisingly, new-vehicle prices rose 1.6% in the year through September.

The cash-for-clunkers program, by spiking sales, produced shortages for selected vehicles, including the Ford (F) Escape and Chevy Cobalt. Steel and parts for the vehicles were in short supply. In an interview on Oct. 19, General Motors CEO Fritz Henderson said when he asked his staff about the shortages, "the answer came back resoundingly that it was a temporary problem." Still, the financial difficulties of auto and parts makers increase the risk that they won't be able to attract financing for needed expansions.

The Fed would have an easier time if it could focus on just one enemy, deflation. But it can't entirely ignore the opposite threat, capacity bottlenecks leading to inflation. The central bank must be prepared to fight a war on two fronts.

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