What is a central banker to do? Raise interest rates further to ensure inflation comes down; lower interest rates to head off the chance of a recession; or do neither, hoping that everything will work itself out? While it is a close call, in the end I believe that somewhat tighter policy is warranted.
As the Fed is relying on economic slack to bring inflation down, the rate decision requires an estimate of the degree of slack going forward. Unfortunately, economic slack - really the gap between current and potential output - is hard to measure. Not only are estimates of the current level of gross domestic product revised for years after the fact, but the growth rate of potential output - that is, growth in the economy's capacity when resources are used at normal rates - tends to shift without warning.
Just because something is hard to measure does not let policymakers off the hook. Instead they do the best they can. Over the past decade, the Fed's best has been pretty good. The critical decision came around 1996 when Alan Greenspan, then Fed chairman, his colleagues and legions of staff economists realised that the economy's potential growth rate had risen by as much as1 full percentage point from about 3 per cent to close to 4 per cent. A rising long-run growth rate makes it easier to lower inflation and keep it there.
Now, unfortunately, there are reasons to think that the US economy's potential growth rate has fallen as low as 2.5 per cent. This "speed limit" depends on three things: growth in the labor force, capital investment and technological progress. Half the story is demographics and the other half is investment. On the first, both the size of the working-age population and the fraction choosing to look for jobs is growing much less slowly. On the second, overall investment peaked at 18 per cent of GDP in early 2000 and has averaged 16 per cent since then. Corporations are using their hoards of cash to pay extraordinary dividends and buy back stock, not make capital investments. Importantly, most of that investment drop has come in computer equipment. So, to the extent that information technology is responsible for the productivity miracle of the 1990s, there is reason for added concern.
There is tremendous uncertainty about whether the economy's speed limit has fallen, though it may still be3 per cent. But all the risks to this are on the downside and that is where policymakers should be focused.
Returning to the Fed's current challenge, regardless of how it is measured inflation is running about 1 percentage point above what policymakers refer to as their "comfort zone". If potential growth has fallen, then the recent slowing is not just part of a normal cycle, and there is virtually no slack in the economy. Without that slack, inflation will not come down unless interest rates rise further.
This sounds more straightforward than it is. The problem is that a lower speed limit also means a neutral interest rate is lower. With potential growth of 2.5 per cent, the neutral federal funds rate has probably fallen from 4.5 per cent to close to 4 per cent. So, while there may not be much slack now, the current 5.25 per cent fed funds rate target represents a tighter setting than we might have thought. Maybe interest rates do not have to rise after all.
I should note here that I disagree with those who argue that the threat of recession will drive the FOMC to ease quickly next year. At first glance, the decline in house prices seems to support this view. But on closer inspection we see that, as property prices rose over the past several years, consumption did not adjust fully. In the final quarter of 2002, net wealth was 5.2 times personal consumption - still above the average from 1975 to 1995. Recently, that same ratio was 5.8, meaning that residential property values can decline by an extra 20 per cent without creating a collapse of consumption.
A year ago I felt that bringing back the inflation trend to the Fed's comfort zone would require a fed funds rate of 6 per cent. But with mounting evidence that the US speed limit has fallen, I now believe that prudent management of the inflation risks continues to argue for at least one more tightening in the months ahead.
Stephen G. Cecchetti is Professor of International Economics and Finance, Brandeis University, and Research Associate, National Bureau of Economic Research. He is a regular contributor to the Financial Times.