The blissful combination of higher growth and lower inflation that has characterized the U.S. economy since last spring is the inverse of stagflation, the nightmare scenario that followed the oil shock of 1973-74, when higher oil prices produced lower output, lower growth, and higher inflation. The current cycle is fundamentally benign--more output at lower prices--but if policymakers fail to recognize it as such and ignore falling prices because output growth is strong, a global recession could occur.

A little reflection provides a straightforward explanation of the current cycle. The old bugaboo, stagflation, reflects a backward shift of aggregate supply to less output at each price level along a negatively sloped aggregate demand schedule. Output falls, and prices rise. In the inverted circumstance we see today, an outward shift of aggregate supply--that is, more output at each price level-a-long a negatively sloped aggregate demand schedule occurs, and the result is more output at lower prices.

Both types of supply shifts are confusing to policymakers and analysts because most of the time growth and inflation levels are positively correlated, with higher growth tied to higher inflation and lower growth to lower inflation. That is because aggregate demand shifts are typically larger than shifts in aggregate supply. An outward shift in aggregate demand results in a new intersection with a positively sloped aggregate supply schedule at a higher price level and a higher level of output, and a drop in aggregate demand has the opposite effects.

Monetary policymakers are more accustomed to dealing with accelerating increases of aggregate demand that shift out toward the less-elastic region of the aggregate supply schedule where price increases begin to outweigh increases in output. Inflation threatens and monetary policy is tightened so that aggregate demand shifts backward, output falls, and inflation falls. Afterward, monetary policy is relaxed at a point where aggregate supply is more elastic, and noninflationary growth resumes along with the growth of aggregate demand.

Less typical is the benign event where the aggregate supply schedule shifts out because of, say, a large increase in or better application of the stock of capital. The supply curve is not only shifting outward, but also highly elastic if there is an ample supply of labor at steady wages--a likely outcome signaled by a sharp rise in labor productivity when the enlarged capital stock increases the marginal product of labor.  Paradoxically, or so it seems, employment stagnates or falls as output rises because a larger capital stock enhances the productivity of labor so much that it is no longer--at the margin--a scarce factor of production.

Large, positive shifts in aggregate supply driven by a jump in the capital stock that sharply enhances labor productivity are benign, but highly unusual--so unusual that policymakers simply cannot imagine how high noninflationary demand growth can be. Conditioned by decades of overheating problems, they ease monetary policy too little and eschew budget deficits until a combination of persistently falling or stagnant employment and persistent disinflation forces the central bank to push interest rates lower. Resorting to fiscal stimulus, tax cuts, and higher government spending boosts demand fast enough to allow output to rise sharply-even as inflation follows. In technical terms, aggregate demand shifts outward, but a highly elastic aggregate supply schedule shifts out further and results in sharply higher output and lower inflation.

Misreading the Current Cycle

Since last spring, the United States has experienced the apparent happy paradox of sharply higher growth but lower inflation. However, listening to the persistent complaints about higher U.S. budget deficits and the uneasy murmurs about the need for the Federal Reserve to start tightening monetary policy--not to mention grave concerns about a weaker dollar (another way to boost aggregate demand)--it is easy to see that many economists and policymakers are clueless about recognizing the type of cycle we are in and how to respond to it.

Most analysts would have predicted that a combination of 6 to 7 percent growth during the second half of 2003 along with a rise in the U.S. federal budget deficit to well over $400 billion and a 15 percent depreciation of the dollar during 2003 would have resulted in higher U.S. interest rates. Some might even have suggested a stronger dollar, especially in view of the superior U.S. growth relative to Europe and Japan.

Instead, during the second half of 2003, when high levels of U.S. policy stimulus boosted demand growth, U.S. inflation and interest rates actually fell. The Fed's favorite measure of U.S. inflation--the year-over-year core PCE deflator--fell steadily, from 1.8 percent in 2002 to a cycle low of 0.8 percent in November of 2003. Now the core PCE (short for "personal consumption expenditures") deflator at 0.8 percent is below the 1 percent level designated by Fed governor Ben Bernanke as the minimum comfort level. Bernanke pointed this out in his talk before the American Economic Association in early January.

"Unwelcome Further Disinflation"

So far, markets have taken little notice of the remarkable combination of sharply higher U.S. growth and sharply lower U.S. inflation. The expected inflation rate implied by yields on TIPS (inflation-indexed Treasury securities) has risen from 1.7 percent in June of last year to 2.3 percent early this year. The failure to notice the remarkable drop in U.S. inflation is due to a combination of three factors: extraordinarily high growth rates during the last half of 2003; the persistent weakness of the dollar; and the sharp rise in commodity prices, especially gold. The rise in commodity prices and the weakness of the dollar are essentially the same thing. Measured in euros, the price of commodities has been constant over the past year.

As Bernanke has pointed out, higher commodity prices have very little impact on overall U.S. inflation. The fact that China's surge in demand for commodities has driven up prices as its growth has soared carries limited implications for U.S. inflation. Bernanke's rule of thumb suggests that a permanent 10 percent increase in raw materials prices would lead to a less than 0.1 percent increase in consumer prices. As Bernanke suggests, rising commodity prices are "a better signal of strengthening economic activity than of inflation at the consumer level."

It is fair to say that the proximate symptoms of inflation, rising commodity prices (especially gold prices) and a weakening dollar, are present, but with that said, there is no evidence that they are boosting broad measures of U.S. inflation, such as the core PCE deflator, which simultaneously drive the actions of the Fed and impact the prices of fixed-income instruments. There is a misleading whiff of inflation in the air, and market participants, conditioned to sell fixed-income securities when early signs of more inflation are manifest in higher growth, higher commodity prices, and a weakening currency, are expecting Fed tightening and higher interest rates.

Interest rates on U.S. ten-year notes have been remarkably stable since peaking in August at 4.5 percent, following a sharp sell-off tied to a perceived change in Fed policy with respect to purchases of long-term notes and bonds. In fact, prior to August, two-thirds of the rise in ten-year yields resulted from a rise in expected real yields (based on TIPS pricing), from a low of 1.5 percent early in June to nearly 2.5 percent in August--an extraordinary and unprecedented move in real interest rates tied to a rapid dismissal of the notion that the Fed would try to fight disinflation by purchasing long-term notes and bonds directly. The other 50 basis points of the rate increase between June and August reflected a rise in inflation expectations from about 1.6 percent in June to 2.1 percent in August. Since then, inflation expectations fell modestly in September and since have risen only twenty basis points despite extraordinarily strong second half growth in 2003. Simultaneously, the expected real yield on ten-year notes has dropped from its high of 2.5 percent in August to about 2 percent early in January. Yields on ten-year notes dropped to about 4 percent by mid-January.

U.S. Excess Capacity Persists

The combination of stable-to-lower real interest rates while a growth surge is accompanied by a fall in broad measures of U.S. inflation points strongly to an important fact. The United States still has plenty of excess capacity. With a highly elastic, outward-shifting aggregate supply schedule, an upward shift in demand has translated into higher output and lower inflation. Another strong clue pointing to U.S. excess capacity is the persistently low real yield on Treasury securities. To put the issue more pointedly, why would an investor who expects that a purchase of more plant or machinery would yield high expected returns of 5 or 6 percent, be content to purchase U.S. Treasuries offering a real yield of just 2 percent?

Treasury securities have not had very stiff competition from alternative uses of funds that would have emerged in a period of burgeoning investment opportunities. It is difficult to escape the conclusion that the U.S. capital stock is still well above a level consistent with long-run equilibrium, where riskless real yields would be in the 3 to 3.5 percent range instead of at about 2 percent. While some risk premium might be necessary to induce real investment as opposed to investment in Treasuries, the normal real yield on ten-year Treasuries is over 3.25 percent, suggesting that even allowing for risk premium, current real yields are abnormally low. The corollary is that expected real yields on capital investment (either inside the United States or elsewhere) are low because the capital stock is still too large.

Some Sectors Support Investment

This is not to say that no investment will take place. It has been clear since last spring that investment has been slowly increasing in the United States. The investment growth has been concentrated in the area of rapidly depreciating capital such as computers and telecommunications equipment. Companies ran down their stocks of that capital after 2000, and by the middle of this year deferred normal replacement cycles, coupled with extraordinarily low interest rates, resulted in increased capital spending. During 2004, accelerated depreciation incentives offered in the tax code may bring forward some additional investment, particularly in the rapid-depreciation sectors that have seen strength so far.

Leaving aside the caveat about telecommunications and electronic equipment, the falling level of U.S. inflation in the presence of powerful demand growth and low real interest rates reinforce the conclusion that, overall, the U.S. capital stock is still above long-run equilibrium levels. Consequently, we would not expect to see a broad-based surge in capital spending. Indeed, if capital spending in particular sectors is brought forward into 2004 because of accelerated depreciation incentives that expire at the end of the year, we may expect to see weaker capital spending in 2005.

Still Lower Inflation to Come

If there still is aggregate excess capacity in the U.S. economy, as suggested by the concurrence of low real interest rates and falling inflation, what can we expect to see in the future? Still lower inflation is a distinct possibility. Given that the U.S. economy has weathered a policy-induced demand surge in the second half of 2003 with still falling inflation, adequate though somewhat lower demand growth during 2004 may produce 4 percent growth while U.S. inflation continues to fall. The cycle that emerged last year could continue throughout 2004.

The persistence of the cycle could be exacerbated by the continuation of extraordinarily low real and nominal interest rates that induced households to add sharply to their stocks of capital equipment. Just as the extraordinary tech boom in the late 1990s led to overinvestment in corporate capital equipment and resulted in excess capacity that is still present, low interest rates are inducing households to invest in real estate and consumer durables, both components of the capital stock that yields services to households. The impact of heavy investment in real estate is already reducing rents, the price of services from household capital. More concretely, as more households purchase real estate either as investment property or as an alternative to renting, rents on residential space fall, reflecting the consequences of overbuilding in commercial real estate during the last decade. Since broad measures of inflation attempt to measure the price of housing services (i.e., rents) and since the price of such services constitutes a large portion of core measures of inflation, past heavy investment in real estate and a rising stock of housing could continue to depress rents for a considerable period of time and, in turn, contribute to lower measures of inflation.

The tech boom resulted in a large buildup of capacity in all areas that persists to this day. Consequently, the Fed has been driven to push down interest rates in response to steadily falling measures of inflation and weak employment data. The weakness of employment growth in the presence of extraordinary demand growth is also, as suggested above, consistent with the existence of excess capacity, especially capital equipment. A large stock of capital was created in the last half of the 1990s that has raised the overall capital-to-labor ratio and thereby boosted labor productivity. The rise in productivity has been enhanced over the past several years as firms have learned how to make refined applications of the larger capital stock as a means to push down costs in an environment of weak pricing power. The need for U.S. producers to compress costs has been exacerbated, particularly in the area of goods produced by China.

China represents immense productive capacity and, in particular, a huge stock of untapped labor that makes it almost impossible for advanced countries to compete at stable prices in labor-intensive production lines. Increased global capacity buildup in more and more sophisticated areas of manufacturing, including tech and communications equipment, has occurred as production facilities have been relocated to China to take advantage of its extraordinarily cheap labor. This is a classic manifestation of the principle of factor-price equalization, where factors of production move internationally in a manner consistent with equalizing factor productivity across countries. It will take a great deal of capital movement to China, more than is currently or prospectively possible, to boost China's capital stock to a point where the marginal product of labor in China implies wages that are anywhere near comparable to wages in industrial countries. China will offer more supply at lower prices in global markets for years to come.

The huge buildup in U.S. productive capacity, with backup excess capacity in China, suggests that the returns to broad-based, large capacity additions in the United States will be low. Hence, the low expected real interest rate on Treasury securities and the suggestion that the U.S. capital stock is still larger than it will be in the long-run equilibrium. Extraordinarily accommodative Fed policy is now resulting in an extra buildup in household capital stock, particularly housing that will, in turn, depress rents.

The excess capacity in the auto industry worldwide, combined with low interest rates that induce households to add to the stock of automobile capital, has resulted in strong automobile sales along with lower prices. In the United States, auto sales are driven by "incentives" offered by auto companies to induce households to add to their stock of transportation capital. General Motors' Daewoo is offering -1 percent interest rates to auto buyers in Korea.

If the picture of continued excess capacity is correct, we should expect to see a continued fall in inflation as a reflection of an ever-rising stock of household capital that reduces the price of services from such capital. The housing sector is the most compelling example, but other examples could include medical care. Low interest rates increase the stock of capital providing such medical care while falling prices press corporations to seek lower costs of providing medical services to their employees. The growth in health care facilities results in some success from such negotiations that, in turn, reduces the cost of medical services, which further depresses inflation rates.

Currency Implications

The weakness of the dollar is another symptom of excess capacity and low real returns in the United States. During the late '90s boom, rising U.S. current account deficits coincided with a rising dollar because real returns on investment in the United States were high and rising. Now the reverse is true, as real returns have dropped and U.S. excess capacity implies a need to shift demand onto U.S. productive capacity to avoid outright deflation like that still being experienced by Japan. While rapid growth makes it seem that the United States ought to be an attractive place to invest, the fact that the rapid growth is demand induced (a large demand shift along a highly elastic, outward-shifting supply schedule) is consistent with low U.S. real interest rates that fail, appropriately, to attract more investment. The United States does not need more investment because it does not need more capacity. As a result, those seeking higher real returns must go elsewhere--perhaps to parts of Asia that are tied to China's boom or to Europe, where real interest rates are too high by virtue of an overly tight monetary policy administered by the European Central Bank. Alternatively, those seeking higher real returns simply purchase assets such as bonds issued by emerging-market governments or by corporations with lower credit ratings.

The dollar will probably remain weak in this environment, especially as Asian central banks are forced to abandon their dollar-support programs. Private foreign investors are prepared to finance U.S. current account deficits when U.S. real interest rates on investment and capital are high, but seem less inclined to do so to subsidize capital acquisition (housing and autos by U.S. households). If U.S. productivity growth falters, as the limits to refinements on applications of new capital equipment are reached, U.S. growth can slow. In addition, if falling U.S. inflation forced the Fed to push interest rates down further or not to raise them as scheduled, the dollar could fall as well.

Policy Implications

The most obvious implications that arise from the proposition that in the face of strong real growth rates U.S. inflation will continue to fall are tied to prospective Fed policy. The high growth rates, weakening dollar, and rising U.S. budget deficit all have markets expecting Fed tightening by mid-year. Beyond Bernanke, Federal Open Market Committee (FOMC) members, so far, have chosen not to make specific reference to the fact that the PCE core deflator is below its preferred lower bound of 1 percent and has been at or below that level since July. After its January 27-28 policy review, the Fed noted that hiring remained "subdued" and continued to ignore the lower inflation numbers that appeared in December.

Looking ahead the Fed will either have to say that it expects the inflation rate to go back up or it will have to reinstate its concern about "unwelcome further disinflation." The next report on personal income and consumption that contains estimates of the personal consumption deflators will appear in early February, as will the employment report for January. Chairman Greenspan will have an opportunity to comment further on falling inflation data and tepid employment growth at his biannual testimony to Congress on February 11.

U.S. budget deficits have not, contrary to widespread warnings, led to higher U.S. interest rates even in the presence of a rapid acceleration of U.S. growth. The reasons are twofold. Falling inflation has kept inflation expectations in check, while low real returns have meant limited competition from alternative uses of funds for the rising supply of Treasury issues. Banks, whose loans to industry have rapidly fallen, consistently with low real returns and a falling money supply, have taken to the familiar spread play--borrowing funds at the front end of the curve, purchasing longer-term Treasury securities, and benefiting from positive carry and rolldown along a steep yield curve. The banks' need to resort to yield curve plays will probably intensify as the mortgage market cools.

Refinancings, which require steadily falling interest rates to grow, have already dropped sharply since mid-year, and, while housing remains strong, new and existing home sales purchases have dropped slightly over the past two months even as housing starts have increased. In other words, excess supply may be developing in the housing sector as well. Beyond this, central banks in Asia fighting to avoid importing deflation (excess capacity) from the United States have been buying dollars and, in turn, U.S. Treasury securities to the tune of $300 billion during 2003.

The outlook for the stock market, at least over the near term, should be positive. Falling inflation will keep interest rates low or falling. The companies that perform best should be those best able to maintain earnings in an environment of excess capacity and limited pricing power. Companies that produce cost-saving equipment should outperform companies that produce capacity-expanding equipment. Companies that produce consumer goods should do relatively well in the environment of low or falling interest rates, provided that they can contain or continue to cut their costs. The need to contain costs means that few companies will hire more labor.

Watch Disinflation, Not Growth

Fed governors like Ben Bernanke remember the Japanese nightmare of the mid-1990s. The currency actually starts to rise once disinflation becomes deflation and policy interest rates reach zero, so that as deflation continues, real interest rates rise. No one on the FOMC wants to go there, though few beyond Bernanke currently believe that that is even a remote possibility. Such disbelief suggests that the emergence of the possibility of actual deflation will come as a bigger shock to the core of the FOMC and thereby drive those members to more drastic action once it becomes obvious.

The current cycle in the United States is confusing to many markets as it offers up numerous apparent market paradoxes, as a weakening dollar and stable interest rates in the presence of rapidly rising commodity prices and a sharply increasing budget deficit have already shown. It is worth adding that a rise in the price of gold is fully consistent with low expected real returns on productive capital. Gold, the "sterile" asset, is an attractive alternative for those trying to store wealth, especially in China and parts of emerging Asia where opportunities to invest in alternative instruments are limited. Beyond that, low real interest rates have also encouraged aggressive purchases of risky assets, so that the higher nominal returns on such assets have been driven closer to the returns on "riskless" Treasury securities.

In short, we have a vision of a great deal of liquidity looking for high real returns and failing to find it. Markets appear to believe that ultimately gold will be a superior store of purchasing power in a world where central banks will be forced to make aggressive reflationary moves. That said, the progress of a move toward reflation in spite of aggressive easing policies by the Fed has been limited. Rather, the Fed's efforts and the extraordinarily low borrowing costs have led investors to purchase risky assets and gold as alternatives to investment and increases in productive capacity. The substitution effect favors risky assets and gold.

It remains to be seen whether inflation will ultimately emerge as a problem and push more investment into gold and out of risky assets as central banks are forced to tighten. Alternatively, and more likely in view of rhetoric heard to date, fears of inflation could cause monetary policy to remain too tight in the first place as confusion over the current economic environment results in a focus on high growth as a harbinger of rapid reflation. In that case, we shall see deflation and global recession--the dark side of excess capacity--as the current benign cycle turns into a nasty combination of lower growth and falling prices, while wealth destruction tied to falling asset prices pushes down aggregate demand. Policymakers who fail to learn the lessons of past post-bubble errors--such as those made in the United States in the 1930s and Japan since 1995--are doomed to repeat them.

As an expert on the Great Depression and a close observer of the Japanese experience, Bernanke understands well the dangers inherent in the excess-capacity problem that underlies the overtly benign combination of higher growth and lower inflation we are seeing in the United States. One hopes that the same is true of Chairman Greenspan and a majority of the Open Market Committee. A lot is riding on it.

John H. Makin is a resident scholar at AEI.