Fears of higher interest rates are based on the notion that the economy has a "speed limit" beyond which inflation will reappear.
Fresh data about business conditions are instantly pored over to find out whether the economy is cruising beyond that limit-or, as economists say, "growing beyond its potential."
But the speed limit-currently said to be 2.1% annual growth in gross domestic product-has drawn skepticism as inflation has remained low while the economy has mostly run in the red zone.
The limit may actually be twice as high as thought, according to a new study by Lacy H. Hunt and Van R. Hoisington of Hoisington Investment Management Co., Austin, Tex.
If so, the economy has actually been running below its potential. And that, along with global developments, would help explain why inflation has been falling instead of rising.
"The crux of the argument on the future of inflation is the rate at which the economy can safely grow without creating upward price pressures," Mr. Hunt and Mr. Hoisington said.
The center of the debate is an economic hypothesis called the "output gap theory." It holds that when actual GDP growth exceeds the potential growth rate, or safe-speed limit, the "inflationary gap" spawns upward price pressures.
"Under this theory, inflation should have accelerated long ago," Mr. Hunt and Mr. Hoisington pointed out. "Instead the inflation rate has declined significantly."
But the output gap is not just theoretical, they said. "The Federal Reserve used it to justify the March rate hike, and many respected voices remain concerned about an imminent upturn in inflation."
Inflation typically rises late in an economic cycle. But while the current expansion is now in its seventh year and the "output gap" has reached a huge 1.3%, inflation remains on the wane.
By some measures, inflation during the past year has been at its lowest level since 1966. Wholesale prices, as measured by the producer price index, actually declined by 0.2% during the past 12 months.
The economy's potential growth rate is based on two factors-productivity gains and increases in the labor force. Mr. Hunt and Mr. Hoisington think both are "growing much more rapidly than assumed, thus boosting potential GDP."
The 2.1% speed limit was specified by the Congressional Budget Office, assuming annual growth of 1% in the labor force and 1.1% in productivity.
Manufacturing-sector productivity is up 3.5% during the last four quarters. Service-sector productivity is harder to measure and presumed to be lower, but computerization and other advances surely mean it is growing rapidly, Mr. Hunt and Mr. Hoisington said.
Meanwhile, the labor force grew 1.9% in the latest 12 months. "But the usable labor force may be growing even faster," they said. "In recent years, about 500,000 undocumented aliens have been entering the country.This alone boosted the effective work force by another 0.3% per annum."
Mr. Hunt and Mr. Hoisington think overall productivity gains may be running at 2.5% annually and the labor force growing 1.5%. That would mean the potential for noninflationary economic growth is 4%, not 2.1%.
But even adjusting the potential by only half a percentage point, to 2.6%, would mean the economy has mostly been growing below its potential, they said. If so, the disparity in output is actually a deflationary gap, explaining why inflation is falling.
A 2.6% real growth rate is above the most optimistic expectations of business economists, and a 4% pace would be dramatic.
Earlier this year, President Clinton's Council of Economic Advisers suggested the economy's safe long-term growth rate was 2.3% per annum, not 2.1%. Most estimates have not ranged above 2.5%.
The stakes involved in the economy's potential growth rate are huge. Small differences in real economic growth translate into enormous differences in the nation's standard of living.
"Whether the economy can grow at 2.3%, or, say, 3% a year may seem a quibble, but that annual seven-tenths of a percent is hardly trivial," according to two academic economists, Barry Bluestone and Bennett Harrison.
"Between now and 2007, the total difference between those two rates is $3.1 trillion worth of GDP-an average of more than $300 billion a year," they wrote recently in American Prospect magazine.
That much extra growth would eliminate problems with Social Security, close the federal deficit, and fuel big gains in employment, wages, and family incomes, they said.
"Misreading the economy's speed limit has its costs," said Mr. Bluestone of the University of Massachusetts and Mr. Harrison of New York's New School for Social Research.
That is particularly true if investors temper their expectations according to lower-than-necessary growth forecasts and limit investments in new technology, plants, and equipment out of concern that sluggish demand will diminish returns on capital.