Economic Forecast: Slow Job Growth and Inflation

Even though employment growth will be sluggish, we could see an upturn in inflation somewhat earlier than in past recoveries.  There are several reasons for this.

First, the dollar is vulnerable to a decline. Foreign investors may be saturated with U.S. assets, and as they become less willing to absorb American securities our currency may decline. This would boost the prices of goods that come from overseas.

Second, the heavy reliance on government stimulus means less use of the natural forces of supply and demand to guide economic activity. Government might raise demand for workers where it already is strong (in health care, for example) rather than where it is weak. This could put upward pressure on wages and prices in high-demand sectors even though there is continued high unemployment in low-demand sectors.

Third, we will be in a situation in which the Federal Reserve faces considerable pressure to provide excessive monetary growth.  In retrospect, the Fed policies from 2001-2003 are viewed by many economists as too expansionary, helping to ignite the housing bubble. However, at the time, a number of economists, citing the “jobless recovery,” argued that Fed policy was too tight (see the citations of Brad DeLong and Paul Krugman in this article written in 2002.). If we go into an election year with an unemployment rate of 7.5 percent or higher, it is safe to say that the politicians will not support any Fed tightening, even if inflation has begun heating up.

I expect that growth in real GDP will pick up strongly over the next year, as pent-up demand for new household formation and durable goods purchases produces a strong rebound. However, for reasons given above, employment growth will be sluggish while inflation pressures will slowly build. Thus, the scenario might be as follows: In 2010, unemployment averages 8.25 to 8.75 percent, with inflation between 1.0 and 2.0 percent; in 2011, unemployment averages 7.5 to 8.0 percent, with inflation between 2.0 and 3.0 percent.  In 2012, unemployment averages 6.5 to 7.5 percent, with inflation between 3.0 and 4.5 percent. Those numbers will probably be good enough to enable President Obama to get re-elected, but his second term will be plagued by rising inflation, high interest rates, and unsustainable deficits, along with stubbornly high unemployment.