The U.S. economy, and with it the global economy, is poised on a knife-edge. Given cost-cutting and deferred capital replacement, a dramatic boost in demand growth aimed at stabilizing, even boosting, falling inflation is urgently needed to launch a sustainable global recovery. Conversely, static to weaker demand growth will lead to lower inflation or even deflation. Either outcome will force the continuation of another round of layoffs that, ominously, has already begun in the United States.

Complacent Policymakers

Sadly, policymakers remain complacent, increasing the likelihood that demand growth will falter and recession will return. With the Iraq war largely over, the uncertainty about its impact on the economy that has kept the Federal Reserve and other central banks on hold will soon be behind us. With utilization rates of U.S. manufacturing capacity at twenty-year lows while inflation continues to fall, we shall no doubt find that the war had little impact on a demand-starved global economy beyond delaying or reducing much-needed stimulus from monetary and fiscal policy. Ironically, the best hope for the intermediate term would be a sharp drop in the U.S. stock market. That would galvanize the Fed to cut short-term interest rates by another 50 basis points.

Focusing on the stock market is appropriate. The market provides a daily, forward-looking estimate of how companies are adjusting in the post-bubble environment. Over the last year, many companies have engaged in cost cutting as the best way to enhance profitability in an environment of weak demand growth. Replacement of equipment has been delayed. Capital spending (business fixed investment) in the fourth quarter of 2002 was 1.7 percent lower than it had been a year earlier, showing some signs of revival at year-end. Labor costs have been cut and continue to be reduced--465,000 jobs were lost in February and March of this year alone. The cost cutting bore some fruit, however. Year-over-year after-tax profits in the fourth quarter of 2002 rose by 10.3 percent, although after allowing for changes in inventory value and depreciation, profits actually fell by 1.9 percent. The substantial impact of depreciation on profitability suggests that cutting costs by not replacing equipment has contributed to profitability. Disconcertingly, capacity is falling along with capacity utilization rates.

The knife-edge image of the economy is meant to strongly suggest that the Fed's waiting-game approach to further stimulus is a risky one with a substantial downside. The Fed is on hold when, in fact, it may well need to be moving toward a new inflation-targeting regime, or at the very least, be reducing the federal funds rate by another 50 to 75 basis points. If the Fed loses its bet that the U.S. economy will recover once wartime uncertainty lifts, additional cuts in the fed funds rate would signal to markets that a new inflation-targeting regime is under serious consideration. That fact may account for the Fed's unusual reluctance to ease or even to signal a possible easing at a time when the risks of economic weakness clearly outweigh the risks of inflation. A new regime of low but not zero or negative inflation targeting, as opposed to the current interest-rate-targeting regime, has long been rejected by Fed chairman Greenspan along with most other central bankers. Ironically, by delaying a further interest rate cut at a time when the economy is vulnerable, the Fed may be forced to an inflation-targeting regime in a U.S. double-dip recession.

Inflation Targeting Needed at Extremes

The failure of central banks to move away from an interest-rate-targeting regime to an inflation-targeting regime is, unfortunately, easy to understand. The appeal of targeting short-term interest rates is strong because the fed funds rate is a proximate target that the Fed can always hit. It works well when the desire is to slow the economy, since it signals the Fed's willingness and ability to slow the flow of credit and increase its cost when the Fed's fear is that demand growth is outrunning sustainable output growth, thereby threatening inflation.

However, interest-rate targeting has it limits even when the desire is to quell inflation. In October 1979, the then-new Fed chairman, Paul Volcker, abandoned interest-rate targeting for a money-growth target that would produce price stability. Of course, when the central bank restricts money growth at a time when inflation and inflation expectations are rising rapidly, interest rates can rise without limit. And short-term interest rates did shoot up above 20 percent in 1980 before the market finally concluded that Volcker was both serious about controlling inflation and willing to inflict serious pain on borrowers to achieve his goals. The economy slowed sharply, entered recession in the first quarter of 1980, recovered briefly, and then reentered recession in the third quarter of 1981 before starting a rapid recovery in 1982.

It is still tempting and arguably prudent to call now, as we first suggested in the December 2002 Outlook, for a "reverse Volcker" move by the Fed, in which interest-rate targeting is abandoned for higher inflation targeting. The problem--the reason central banks in the two major post-bubble episodes of the twentieth century (United States in the 1930s and Japan in the 1990s and beyond) failed to make the transition to a new, higher inflation-targeting regime--is twofold. First, a sense of urgency does not develop in a disinflationary period. As inflation drifts down, the move is at first welcomed, a kind of reward for an inflation-fighting central banker. As inflation reaches 2 percent, then 1 percent (the current core CPI inflation rate is 1.7 percent year-over-year; 0.8 percent at an annual rate over the last three months), concern arises, but the interest-rate instrument is still seen as having traction. The belief persists at the central bank that one more cut will revive the economy. Often the cut does produce a temporary respite and a rise in the stock market as in the first half of 2002. If excess capacity persists, however, employment and output growth falter, and another rate cut is required as we saw in November 2002 and, arguably, as we are seeing today with the federal funds rate at just 1.25 percent.

The second problem with the transition to proactive inflation targeting in a post-bubble monetary regime lies with an apparent abhorrence among central bankers, after a lifetime of fighting inflation, to overtly target higher inflation. The Bank of Japan displayed great virtuosity with disastrous consequences for the Japanese economy with its ability to invent reasons to avoid inflation targeting even long after it had pushed short-term interest rates to zero. Inflation targeting would not work was one rationale, often followed by the totally inconsistent claim that inflation targeting could lead to hyperinflation. There was "good" deflation from structural reforms as opposed to "bad" deflation from inadequate demand growth. In the end, the Bank of Japan, under the unfortunate leadership of a prayerful Governor Masaru Hayami managed to dissemble for five years as Japan's economy and stock market languished, unemployment rose, and, insidiously, prices drifted ever lower. The new governor, Toshihiko Fukui, is off to an inauspicious start. He continues to dither while watching the stock market fall as longer-term interest rates drift downward toward 60 basis points and heavy intervention is necessary to keep the yen from appreciating--all clear market signs that deflation is intensifying in Japan.

Target Higher Inflation

The Federal Reserve is, disconcertingly, following the pattern of post-bubble intransigence almost to a tee. Faced with a rapidly weakening economy in March, the Fed's Open Market Committee declared itself unable to determine where the economy was growing and blamed the Iraq war for the uncertainty. While some Federal Reserve governors have discussed buying long-term securities and targeting inflation, they all hasten to add that they see such measures as unnecessary.

The near-term economic data, as it always does, has provided a mix of gloom interspersed with rays of hope. The manufacturing sector continues to weaken, as the monthly Institute of Supply Management (ISM) Survey has dropped below 50 percent, suggesting contraction, and will probably fall further in coming months. Employment has begun to drop again with, as already mentioned, the loss of 465,000 jobs during February and March. This is an ominous sign since it suggests that companies have resumed cost cutting measures in the absence of a recovery of demand growth. Consumer sentiment has recovered modestly after the end of the intense phase of the Iraq war. The University of Michigan's Consumer Sentiment Index for April rose to 83.2 from 77.6 in March. This took it back close to the average for the previous six months but was a weak advance compared to the 17.3-point bounce after the first gulf war ended in March 1991.

The biggest positive surprise in the economic data was a sharp jump in retail sales during March, which more than reversed a sharp drop in retail sales in February. The jump was led by higher auto sales and higher sales of building equipment. The retail sales jump in March appears to be the result of dumping unwanted inventory accumulated during February. This interpretation is underscored by a drop of industrial production in March of 0.5 percent, which brought capacity utilization in the manufacturing sector down to 72.9 percent--the lowest level in twenty years. If producers saw the jump in March retail sales as the start of a sustainable demand recovery, output would have increased and other real-time manufacturing indices, such as the ISM Index, would have moved above 50.

The basic problem with the economy continues to be that after-tax disposable income growth is weak and consumption is weak as a result. Interest rate cuts have not worked over the past two years, because as market interest rates fall, a drop in expected inflation reduces the drop in real interest rates. Indeed, it is possible that with demand weak and excess capacity still present, only a negative real interest rate will stimulate demand growth. The only way to push the real interest rate below zero is to push up inflationary expectations. That is why a recovery of demand growth will require that the Fed target a higher inflation rate.

Oil and Taxes

Some analysts have pinned hopes for an economic recovery on the fall in oil prices after a reduction of uncertainty surrounding the Iraq war. Leaving aside the fact that oil prices have yet to come down much--they briefly spiked to $38 a barrel and now have returned to last December's level of just below $30 a barrel--the effect of oil prices on the economy apparently is not well understood. Many have forgotten that oil prices rose during 2002. Careful empirical analysis of the impact of oil prices on growth suggests that the effects occur with a lag of about six months. The reason for the lagged negative impact of higher energy prices is easy to imagine: when consumers confront higher energy prices (say at the gasoline pump), they do not immediately reduce consumption, but simply pay the higher cost of filling up their tanks. As the higher energy costs result in higher energy bills, households gradually (apparently over a period of about six months) reduce spending on other things, thereby putting a drag on growth. Empirical estimates suggest that the sustained increase in energy prices during 2002 will impose a drag of about 0.8 percent on GDP growth during the first six months of 2003. The additional jump in energy prices between November 2002 and March 2003 will presumably impose a further drag on growth during the second half of this year.

The reduction in the size of President Bush's stimulus package, effectively from a ten-year total of more than $700 billion to about $350 billion, is a move in the wrong direction. The economy needs higher after-tax disposable incomes to stimulate demand growth and an end to double taxation of dividends to boost stock prices. While the Bush administration has fought hard for maximum tax cuts, probably the best that can be hoped for would be scaled-back tax cuts enacted in July of this year and made retroactive to January. That measure would provide a total stimulus in the form of increased after-tax-income growth totaling about $140 billion during 2003 and 2004, enough to add about a half a percentage point to growth. In short, the tax cuts have been reduced to a level that may just compensate, with some lag, for the increased cost of energy during 2002 and the first quarter of 2003.

The High Price of Change

Taken altogether, the lackluster performance of the economy, the distraction of the war, and the hesitation by the Fed and other central banks, coupled with a sharp scaling back of U.S. fiscal stimulus, make it likely that by the end of this year we shall see the Fed targeting higher inflation after having been unable to avoid a U.S. double-dip recession that precipitates a global recession. Needless to say, we can all hope that this will not be the case, but history has shown that the moves by central banks to target higher inflation rates and thereby stimulate demand growth are undertaken only with the greatest reluctance, if at all.

John H. Makin is a resident scholar at AEI.