Sluggish Growth, Little Inflation

07/27/2009 12:00 pm EST


David Wyss

Adjunct Professor, Brown University

David Wyss, Standard & Poor’s chief economist, says high unemployment and a strapped consumer will keep healthy growth or inflation from surfacing for some time.

We still believe the economy is on track to hit bottom in the fall, but it isn’t there yet. The recovery promises to be a very soft one, in our view.

The consumer remains the key. Sharp declines in household savings fueled the last two economic expansions, which allowed consumption to lead [gross domestic product]. After this recession, we expect the saving rate to rise rather than fall. How high it climbs will likely determine the strength of the expansion.

The economy has shed 6.5 million jobs since December 2007, with employment declining for a record 18 consecutive months. A surprise has been the rapid rise in the unemployment rate, which increased even more quickly than we expected.

The biggest element in the rise of unemployment has been the stronger-than-usual performance of productivity. Over the last four quarters, while real GDP dropped 2.5%, productivity actually rose 1.9%. In the last seven recessions, productivity fell by an average of 0.6% during the worst four quarters, despite an average GDP loss of only 1.2%.

[Meanwhile,] we see no reason to worry about inflation in the medium term, but it could become a factor once the economy recovers. Until the economy gets to full employment, however, inflation is virtually never a problem. Because we expect the recovery to be very slow, it will likely be at least five years before we reach full employment.

There could be some inflationary pressures in the medium term from a weaker dollar and higher commodity prices. A weaker dollar creates inflation because of the direct impact on the prices of imported goods and from the indirect impact of providing a higher price umbrella for US producers.

Heavy government borrowing could cause the dollar to drop, but it won’t necessarily do so. In the early 1980s, for example, the heavy government borrowing raised interest rates enough to actually increase capital inflows, strengthening the dollar. At present, however, we expect the heavy reliance on foreign capital to push the dollar lower.

Commodity prices have rebounded after the sharp drop at the end of last year, but so far this seems to be only a correction after a swing away from the overheated levels of a year ago. Now we are moving back towards normal, but the possibility of a new commodity bubble shouldn’t be ruled out.

We think the Federal Reserve will largely ignore commodity prices in setting monetary policy, as it should. The Fed has no control over these prices, which are set in international markets. The Fed should focus on domestically generated inflation, which is why it emphasizes the core inflation rate.

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