THE United States economy has used up all of the excess industrial and labor capacity that the 1990-91 recession and subsequent slow recovery generated. It is thus poised for an acceleration in inflation. Shortages of goods, services, and skilled workers will drive up wage costs and inflation.
That picture may seem ridiculous to today's jobless or to business executives trying without much success to boost prices. But it is what Federal Reserve economists have been telling the system's policymakers. Those studies have something to do with the startling decision Feb. 4 by the Federal Open Market Committee policymakers to raise short-term interest rates.
``This is the first time in over 25 years that the Fed has changed policy on the basis of a forecast - not on the basis of the actual numbers,'' notes Michael Keran, chief economist of Prudential Economics. The Fed has often responded to strong economic growth or rising inflation. But the actual price indexes show no rise in the inflation rate in the past year. And there was still 8.7 million unemployed Americans in January.
To Mr. Keran, the Fed made ``a mistake'' in ``prematurely'' raising interest rates and thereby riling financial markets. His calculations indicate that the economy has more room to grow before it gets to a level where inflation will pick up speed.
But to Stuart Weiner, an economist at the Federal Reserve Bank of Kansas City, the economy has already reached the ``natural rate of unemployment'' - the unemployment rate at which there is no tendency for inflation to change. When demand is strong enough to push the actual unemployment rate below that rate, inflation increases. If the jobless rate goes above that natural rate, then inflation will diminish, this economic theory holds.
In an article in his bank's latest quarterly publication (Economic Review), Mr. Weiner estimates the natural rate at 6.25 percent. Since then, the Labor Department has revised its method of surveying the public to obtain the unemployment rate. The new method of counting boosts Weiner's natural rate to 6.75 percent. So the actual January rate of a seasonally adjusted 6.7 percent is already below the natural rate.
Keran, however, puts the natural rate at 5.5 percent under the new measurement system, with room to spare for noninflationary growth. (February employment figures are to be released today.)
All this may sound theoretical. But if the Fed acts on such analysis, it affects job prospects and prosperity for all Americans.
Keran figures that the economy has the capacity to grow about 2.75 percent a year in real terms. The Fed's econometric model estimates a more modest 2.5 percent. Over some years, that apparently minor difference adds up to a major difference in the level of potential national economic output.
At the Fed branch in Chicago, economist Kenneth Kuttner calculates that the actual output of goods and services in the US is already about at its ``potential'' level - the maximum the economy can produce without inflation rising.
By Keran's estimate, there is about 1.6 percent of excess capacity in the economy, even after output surged upward at a hot 7.5 percent annual rate in the fourth quarter of 1993.
Mr. Kuttner admits that his estimate of the potential output is subject to a possible error of 1.2 percent on either side. But the fact that inflation has not diminished more than it has in the past two years indicates that actual output has been closer to potential output than is generally realized, he argues.
Keran says the inflation numbers in the next year will indicate whether he or the Fed economists are correct in estimating the level of noninflationary capacity in the economy. If inflation drops further, he will claim victory. If it rises, the Fed economists can crow.
The debate has policy implications. If the Fed economists are right, the only way to lower unemployment now without inflationary consequences would be to tackle ``structural'' unemployment by such measures as improving education and job training, refining unemployment insurance, and helping the jobless relocate to job vacancies. If Keran is correct, the Fed won't need to raise interest rates as rapidly in order to slow growth. Keran says he expects the Fed to shove up interest rates another 0.25 percent within the next few months as it awaits more inflation numbers.