The Fed is now arguing that these indicators do not forecast inflation mainly because there is unused capacity. For example, on Nov. 6, Fed Governor Ben Bernanke, said this: "I believe that the current low level of inflation, the expansion of aggregate supply by means of ongoing productivity growth, and the high degree of slack in resource utilization together leave considerable scope for a continuation of the currently accommodative monetary policy without undue risk to price stability."
Last week, Michael Moskow, president of the Federal Reserve Bank of Chicago, made a similar point. "Economic output is determined by an economy's available labor and capital resources and their productivity," he said. "If actual economic output persistently lingered below its potential, which economists refer to as an output gap, inflation would decline."
Continuing, Mr. Moskow said, "In the past two years, the unemployment rate has increased and capacity utilization rates in the U.S. have declined. Both movements suggest that the level of actual output has been falling short of potential, so there is an output gap."
Translated into English, the Fed is saying that it will continue pumping up the money supply and maintaining easy credit conditions for a "considerable period," as it said in a recent statement. Its view is that the economy is like a bucket that has been partially drained. Until the bucket is full again, there cannot be inflation. Therefore, the Fed will continue stimulating demand indefinitely.
The problem with this theory is that it is not borne out by experience. In the 1970s, there was high unemployment and low capacity utilization, yet high inflation. A key reason is that labor, plant and equipment are not homogeneous. When demand is stimulated, it may require workers with different skills in different places to satisfy. Similarly, producers may not have the right equipment to make the things people want. Therefore, new investment must take place first before production can rise.
Although the Fed's capacity utilization index may be at a historical low of about 75 percent, much of that unused capacity is worthless. It is malinvestment that simply must be written off. This means that inflation could easily reemerge well before capacity hits 82 percent, generally considered the tipping point. It also means that unused capacity is no barrier to new investment.
I believe that the message of markets, which is showing signs of inflation, is a more accurate indicator of future prices than the capacity utilization index or the unemployment rate. If the Fed continues easing, it runs the risk letting the inflation genie out of the bottle. A little tightening now would be prudent, forestalling more severe tightening later.