The Premature Exit

William Mcchesney Martin, America's longest-serving central banker, once quipped that it's the job of the Federal Reserve to "take away the punch bowl just as the party gets going." His lesson seems to have been a bit too well taken by today's leaders, who lately seem more concerned with the irrational exuberance of tomorrow than the anemic economy of today. Recently German Finance Minister Peer Steinbrück asked world leaders to consider coordinated "exit strategies" from the trillions of dollars' worth of stimulus programs enacted in the past year. Soon after, the heads of Australia and South Korea teamed up to offer concrete policies for "unwinding the policies of the crisis." To varying degrees, the U.S., U.K., France, and other major nations have also exhorted the world to start thinking about how to end the loose-money policies of the past year that kept interest rates low and handed free cash to consumers.

All the talk is worrisome, because if leaders pull back from stimulus too soon, they'll be taking the punch bowl away from a party that hasn't even started yet. The key factor pushing policymakers into the hasty retreat is, of course, the risk of inflation. It was the great bogeyman of the 1970s, and since its defeat in the 1980s, every central banker and economic policymaker has assiduously guarded against its return. But during the past 12 months of recession-fighting, every major nation slashed interest rates, handed out stimulus checks, and turned on the printing presses to keep credit flowing through the financial system. Now experts worry that the extra money and debt will take the world back to the 1970s.

Yet in order to have inflation, you have to have a significant upswing in demand. While Federal Reserve chairman Ben Bernanke has all but declared the recession over, and the unemployment spike in the U.S. and Europe seems to be flattening, there is still too much slack in the developed world to make inflation a serious short- or even medium-term concern. Price levels start to rise when too much money chases too few goods. But right now, factories are sitting idle, warehouses are full, and laid-off workers are so discouraged by the job hunt, they're spending more time in front of daytime soaps than Monster.com. As of August, only 70 percent of American manufacturing capacity was in use, according to Bloomberg. That's below the long-run average of about 80 percent, and lower even than the depths of the last recession. Canadian factories are even less busy, and rates are only marginally better in France, the U.K., and Germany. The labor market is torpid: the recession has eliminated 7.4 million jobs in the U.S. alone. And in each recession since 1991, unemployment has taken longer and longer to fall back to normal levels, meaning it could be years before the loose labor market tightens up.

Furthermore, with inflation, expectations matter: if a factory owner expects his costs to rise 10 percent a year, he'll plan to hike his own prices by an equivalent amount, which can trigger a snowball effect of rising prices. Right now, there are no signs this is happening. The flight to gold, which recently climbed above $1,000 an ounce, has been wrongly interpreted as a sign that investors expect a horrid bout of inflation. Gold is a haven from inflation, true, but investors buy gold to guard against all kinds of ills other than just inflation, muddying the signal. Bond prices tell a clearer story, and they imply an annual inflation rate of just 1.85 percent over the next 10 years, which is below average.

And as any new driver can tell you, it's a lot easier to jam on the brakes than to rev the engine. The central bank's favorite tool for spurring the economy is to lower interest rates. But as economist Paul Krugman likes to point out, interest rates can't go lower than zero—unless you're willing to pay people to borrow your money—and many developed economies, namely the U.S. and Japan, have already hit that floor. Central banks have essentially shot all their arrows, and if they act too soon to stanch inflation by raising rates, they risk negating the impact of those shots and having nothing left in their quivers when it really matters.

Steinbrück and his colleagues are right to think ahead, but they should be wary of the signals they send to the wider economy. This year the GDP in every G7 country will shrink, in some cases precipitously. Those same countries will experience little to no inflation. There's no need yet to worry about partygoers dipping too heavily into the punch bowl.