Interest rates and the Fed’s great ‘slack’ debate

By Robert J. Samuelson

Call it the great “slack” debate. For nearly six years, the Federal Reserve has held short-term interest rates near zero to boost the economy. Is it time to consider raising rates to preempt higher inflation? The answer depends heavily on the economy’s slack: its capacity to increase production without triggering price pressures. Although economists are arguing furiously over this, there’s no scientific way to measure slack. Economic policymaking is often an exercise in educated guesswork, built on imperfect statistics, shaky assumptions, incomplete theories and political preferences. This is an instructive case in point.

“Slack” is economics jargon for spare capacity. It means unemployed workers, idle factories, vacant offices and empty stores. Its significance is obvious. If there’s a lot of slack, inflation shouldn’t be a problem. Companies and workers will compete for sales and jobs by holding down prices and wages. By contrast, if there’s little or no slack, government efforts to stimulate the economy through low interest rates or budget deficits may backfire. Excess demand will raise wages and prices. (There are some exceptions to these maxims.)

How much slack is there today?

We don’t know.

There are two ways to gauge it. One is to estimate the economy’s “potential output” — its maximum gross domestic product (GDP) — and compare it with actual GDP. This is a top-down approach. How much would the economy produce if it were at “full employment” and all firms sold everything they could make? To arrive at that, economists make assumptions about how many people want to work and how changes in technology, markets and business affect productivity (a.k.a. efficiency).

It’s hardly fool-proof. This year, the Congressional Budget Office reduced its “potential output” estimate by 7 percent for 2017; this slashes more than $1 trillion from the economy’s possible production. The CBO attributed some of the change to the Great Recession: workers retired earlier; businesses and factories shut. But most reductions reflected downward revisions of long-term productivity and workforce trends.

Still, even the CBO’s revised estimates suggest the economy now has considerable slack. In 2013, its gap between actual and potential output was about 4.7 percent of GDP. Case closed? Not exactly. Economist John Fernald of the San Francisco Fed has done detailed estimates that result in a much smaller gap between actual and potential GDP. His gap is 2.3 percent of GDP. If true, the economy is much closer than recognized to an inflationary threshold.

The other way to judge slack is to examine individual sectors for signs of price pressures. Economists commonly look at labor markets on the theory that, if wages are rising rapidly, employers are having to bid aggressively to hire needed workers. That’s not happening now, argues Josh Bivens of the Economic Policy Institute, a liberal think tank. In the past year, bothaverage hourly wages and the employment cost index (a broader measure that includes fringe benefits) have risen about 2 percent — a modest gain roughly equal to inflation over the same period. Wages could go higher without causing an inflationary spiral, he says.

Fair enough. What ultimately matters is whether companies can raise consumer prices. Some already have. Airlines have merged, giving the surviving firms more market power. In the past year, airfares are up 5.3 percent. (Market power is one exception to pure supply and demand.) Businesses have skimped on investment in this recovery; bottlenecks could emerge sooner than expected.

Economic policymaking is not an exact science. Ideally, the Fed would begin raising interest rates sometime just before the economy exhausts its slack. But we don’t know where that point is. A fair reading of today’s mixed evidence is that slack remains sizable — but it may be less than many economists assume. Inflation is low enough that policy understandably remains focused on jobs. Although unemployment has dropped from 10 percent in late 2009 to 6.2 percent, the actual number of payroll jobs is less than 1 percent above its 2008 peak. Half of Americans think the country is still in recession, reports a new Wall Street Journal poll.

The Fed is expected to begin raising rates in 2015, but the time and pace are unknown. The danger of waiting too long or going too slow is that inflation, now controlled in the market and in Americans’ thinking, will escape these convenient bounds. Once that happens — as the double-digit inflation of the 1970s and early 1980s showed — inflation takes on a life of its own and becomes self-fulfilling. It can be suppressed only through tight credit, recession and high unemployment. We don’t want to go there.