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There is a lively debate going on in the United States about how strong the US economic recovery will be and what that will mean for Federal Reserve monetary policy. When will the US central bank begin to tighten, by how much, and how often?
In the past two weeks, half the presidents of the 12 regional Fed banks have commented on the economy and prospects for monetary tightening. Their message is “not yet“. The Fed officials see no compelling need to act now but are, as usual, prepared to raise official interest rates “preemptively“ – that is, before any revival of inflationary pressures.
At least one Fed bank president, Broaddus of Richmond, usually among the inflation “hawks“, maintains that today’s rate of inflation is “negligible.“ And he went out of his way to assert that avoiding disinflation, or what would be worse, deflation, is just as important a goal for the US central bank as preempting renewed inflationary threats.
This line of argument would have been inconceivable in past business cycles. But the experience of Japan over the last several years has had a big influence on Fed thinking. There is now an appreciation of how difficult it can be to revive economic growth by low interest rates when prices are falling, profits are weak, and businesses decide to cut back drastically on capital expenditures. The US situation is different from Japan’s because the US financial system is a lot stronger. But the lesson is valid: do not exaggerate the inflation potential of economic recovery.
That benign view of US inflation prospects stems from three factors. First, the world economy is still weak, excess capacity exists, commodity prices are low (apart from the recent spurt in oil prices), and the dollar is strong. Second, US wage pressures are muted because of the sharp run-up in the unemployment rate. Third, and most important to Fed officials, productivity growth continues to be astonishingly high. That reflects more effective use of already installed high tech hardware and software, more intelligent supply chain management, and a more mature workforce. The productivity achievement holds down unit labor costs and thus can dampen inflationary impulses even if real GDP rebounds rapidly. Therefore, fast growth by itself does not compel a more restrictive monetary policy.
The US bond market isn’t buying this argument. The yield curve for short and intermediate maturities has steepened, meaning a sharply rising Federal funds rate is expected over the next year – at least a doubling to 3.5% or higher from the current 1.75%.
Essentially, the bond market is telling the Fed: “We don’t believe that after such a brief, mild recession the US can have a traditionally robust recovery (growth of 5% or more in its first year) without reigniting some inflationary pressures. You, the Fed, will have to do a lot more tightening than you’re letting on.“
So who’s right: the Fed officials who are attracted to the optimistic view of a fast recovery with minimal inflationary effects, or the bond markets, which go along with the fast recovery hypothesis but see inflationary dangers ahead?
There is another scenario that we think is most likely of all. It consists of a more subdued business rebound, combined with a moderate but gradual pick-up in the rate of inflation. First, US consumers may not be willing or financially able to keep up the furious pace of consumption growth that was responsible for lifting the economy out of recession in the fourth quarter of 2001. Second, it is doubtful US corporations will approve, plan, finance, and implement ambitious capital expenditure programs, especially in the high tech sector.
The outlook for capital mainly depends on how US business managers assess future profits. But even past profitability is hard to measure. Different technical estimates of corporate profits for the fourth quarter of 2001 tell radically different stories. Profits with inventory valuation and capital consumption adjustments showed the sharpest one-quarter increase in over fifty years. But profits calculated only with inventory valuation adjustments showed a further decline. Conditions were especially bad for manufacturing, which registered an outright loss for the first time in a generation.
Statisticians prefer the first measure. But the second is far closer to the impressions of corporate chief executives in many industries, who are worried about a severe profits drought. Their views may matter most, since they are the people who sign off on capital spending programs. In this post-Enron world, their caution may be decisive – and contagious. The implication for the Fed: go slow!
