What the U.S. economy needs - and what the Federal Reserve would surely like to see - is a gentle midcourse correction.
Over the three quarters that end at midyear, the output of goods and services in the United States probably will have grown at a 4% to 5% annual rate. This is well above our long-run growth potential, and has brought the economy quite close to the point where more upward pressure on prices and wages can be expected.
Looking back, the Fed can be pleased that it began the tightening process early this year and that it moved with more speed than many in the market probably expected at that time. The question now is whether there is enough monetary restraint in the pipeline to slow economic growth and keep upward wage and price pressures in check.
Danger Point Unclear
Those pressures generally manifest themselves as the economy nears full capacity. In that regard, there has always been much debate about which particular unemployment or plant utilization rate represents the danger point beyond which accelerating inflation will be unleashed.
Unfortunately, no one can be sure, with history at best an uncertain guide. Every decade or so, the particular trigger point seems to change, affected by unpredictable variations in such elements as labor market structure and the degree to which existing plant has become more or less productive.
But that question in practice may be less important than it seems. Rather, the more important practical question often revolves around the speed with which the economy approaches the general area within which capacity constraints might be expected.
A rapid approach would itself tend to raise inflation before capacity constraints are reached by making business more optimistic and more eager to bid for labor. Also, the overall sense of optimism in such an environment would make it easier to pass price increases along to customers.
In the early years of this recovery, many businesses were disappointed to find that they could not sustain posted price increases. It is now getting easier to make increases stick.
Thus, it is important to slow the growth of the economy even before reaching whatever rate of capacity use is a trigger point for accelerating inflation. Otherwise, inflation psychology may well worsen, prematurely so to speak, as business and labor see themselves in an environment of strongly growing demand for their product without any clear letup in sight.
Indeed, if that were to occur, the trigger point for accelerated inflation would come at lower-than-expected capacity use as a result of changes in market psychology. The life of the economic expansion could thereby be shortened.
The Fed has so far rather successfully kept that from happening. Inflationary pressures remain latent, and evidence for a rise in inflationary psychology is limited.
Evidence is not entirely lacking, however. The relative weakness of the dollar on exchange markets has many causes, with our current account deficit and the lingering psychological effect of our tough-sounding trade policies perhaps the principal ones.
Still, some lack of confidence in the ultimate value of the dollar as a store of purchasing power also has contributed. Some such doubts also help account for the sharp fall in the bond market thus far this year.
The Fed would probably welcome the opportunity to put policy on hold for a while and assess the impact on the economy of its tightening to date.
To avoid further tightening over the summer, they should have to be pretty well convinced that the growth rate of the economy is in the process of slowing to very near its potential - which many would place at a 2.5% to 3% annual rate.
Since, as is well known, monetary policy works with a lag, it would not be until the second half of this year that the principal effects of the tightening to date will begin to be seen.
If, for example, the pace of housing activity or spending on durables showed no signs of a sustained slackening, the Fed could reasonably feel that they had failed to make a real dent in the economy's growth outlook and that the odds on inflationary psychology worsening remained unacceptably high.
I would feel reasonably certain at this point, though, that the Fed is not at all sure what they will find as the year progresses. Some slowing in spending is already apparent.
My bet is that over the second half of the year there will be a clear slackening in growth, but probably not quite enough to convince the Fed that inflation psychology will remain well contained, assuming that the Fed's own sensitivity to the potential for inflation does not itself lessen.