June 8, 2009
Given the extremely low level of interest rates, and the extraordinary amount of fiscal stimulus in the pipeline, some economists are concerned about the possibility of significant inflation at some point down the road. How real are those worries, and when might the Fed begin to tighten?
Let’s talk about the two most likely sources of inflation. The first comes from the labor market and is called “wage push” inflation. When the labor market is near full employment, qualified workers are hard to find. As a result, workers can demand higher wages. Labor costs are the single biggest expenditure for any company, and account for about two-thirds of the price of the product. So when the labor market gets tight and hourly wages begin to climb, inflation is almost certain to follow.
But the unemployment rate is currently 8.9% and likely to be 10.0% by yearend. Most economists believe that full employment in the U.S. is somewhere around 4.5%. There are literally millions of people out there looking for jobs. For the unemployment rate to decline, monthly employment gains must exceed growth in the labor force. The labor force these days is currently growing by about 1% annually, or roughly 150 thousand workers per month. If employment grows by 2% or 300 thousand workers per month (which is a very sizable monthly gain) it will take six years for the unemployment rate to fall to the 4.5% mark. If it reaches a peak in December of this year, it will take until the end of 2015 to fall to a level at which we might worry about a pickup in inflation. This may seem like a very long period of time, but following the 2001-02 recession it took three years for the unemployment rate to fall from a peak of 6.3% to the 4.5% danger point. This time we are starting at the 10.0% mark. Wage push inflation is not going to be a problem any time soon.
The second kind of inflation is commonly called “demand pull” inflation. It occurs when the economy is growing very rapidly and businesses are able to raise prices because demand is so strong. One way of looking at this is to examine the utilization rate in the manufacturing sector. As firms boost production they use more and more of their available productive capacity, and the utilization rate climbs. Economists have found that when utilization in the factory sector reaches the 80.0% mark, inflation tends to rise. But the utilization rate today is 65.8% and falling. By yearend it should be 60.0% or 20 percentage points below the presumed danger point. Following the 2001-02 recession it took five years for the utilization rate to climb eight percentage points – from 71.4% in November 2001 to 79.1% by August 2006. How long will it take to climb 20 percentage points? A long time – perhaps until 2015!
So when might the Fed begin to tighten? We know that Fed policy is wildly stimulative with short-term interest rates essentially at 0.0%. For Fed policy to be neutral, the funds rate should be about two percentage points above the inflation rate. With inflation today between 1.5-2.0%, Fed policy neutral would be neutral if the funds rate were 3.5-4.0%. Thus, the Fed must raise rates by about four percentage points to eliminate its stimulative policy stance. Once the Fed begins to tighten it has historically moved in 0.25% increments. This means that the Fed would need to hike rates at 16 consecutive meetings to get policy back to neutral, and since the Fed meets every six weeks that process would take almost two years to complete. Keep in mind that changes in Fed policy do not impact the economy for another year. So to have the economy slow down by the time that it reaches full capacity, the Fed needs to begin tightening three years earlier. If Chairman Bernanke believes that situation might occur by the end of 2015, then he needs to begin raising rates by the end of 2012. However, the Fed will probably choose to begin sooner and proceed at a more leisurely pace to ensure that their action does not push the economy back into recession. But given the extraordinary amount of surplus capacity in the economy it is inconceivable that Fed tightening will begin prior the end of 2010.
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