Inflation or Disappointing Growth
Disappointing subpar growth remains our outlook for the economy. This subpar growth will be a challenge to both private and public decision-makers. A realistic, not Pollyannaish, view of the economy begins with a model of the economy as it is—not as we might wish it to be. In this respect, we see an economy characterized by an excess supply of goods, an excess supply of labor and an excess supply of credit. Given this model, we will look at the outlines of current monetary and fiscal policies and how these policies have set up their inherently difficult exit strategies. Finally, the implications of our model and the policy contradictions suggest a highly uncertain path for economic growth and credit markets. This path suggests significant risks remain for decision-makers next year.
Economy: Trading at Non-Market Clearing Prices
For observers, the major risk is to interpret current market prices and activity as representing clear trading signals in a free-market economy. Instead, the persistent excess supply of goods and labor suggest that price and labor pressures are still downward. Much of current sales reflects the impact of subsidies to the economy either directly through Federal spending or indirectly through the cash-for-clunkers-type programs and credit allocation by the Federal Reserve. The excess supply of housing, housing-related goods, such as carpets and furniture, as well as autos, is clear enough. Excess inventories of these durable goods can only be cleared through further discounting. Special Federal tax policy credits are intended to stabilize the housing market in the short run but represent a stop-gap measure that may give false hope of a rebound in construction.
In a similar way, much of the hiring in the job market has represented Federal workers or workers hired under the Federal stimulus program. While positive in the short run, these are not private sector hires and do not reflect the viability of the private economy. Moreover, the steady decline in hours worked and in average hourly earnings over the last year suggests continued weakness in earned incomes and thereby private consumer spending going forward.
Unfortunately, public policy has added to the confusion on market signals. Monetary policy has generated an excess supply of credit to mop up the excess supply of goods. This excess credit supply is reflected in very low nominal interest rates which are viewed as unsustainable over time. Moreover, real interest rates are very high relative to a flat path for real GDP. This relationship gives rise to a debt burden that increases faster than the income. In today’s economy, the thrust of fiscal policy is so strong that the monetary authority could lose its control on inflation even if the central bank retains control over the monetary base.1 The growth of the real stock of government debt grows faster than the economy and, as the demand for such debt is limited, then the debt must be financed, at least in part, by seigniorage, effectively printing money and thereby leading to higher inflation.
