Slack Attack: Fed Faces Test on Inflation

By SARA MURRAY and JON HILSENRATH BEND, Ore. -- Tens of thousands of people who moved here in the past decade saw a booming real-estate market and plentiful jobs amid the mountains of Central Oregon. Now they see slack. A year and a half of recession has left local manufacturer Bright Wood Corp. with too much capacity at its plants that make window and door components. Bright Wood has laid off nearly half of its work force, shut an 80,000-square-foot factory in Bend, and sold or stored its extra equipment. The economy was humming in Bend, Ore., but now businesses are closing and foreclosures are booming. Nationwide, such slack, the unused portion of an economy's productive capacity, is helping tamp down inflation fears Additional underutilized industrial space, housing and workers are apparent across town. More than 9,000 people have lost jobs since mid-2006. Some 29% of homes are vacant. "For Lease" signs hang on store windows near the town's main drag, Wall Street. Similar slack -- the unused portion of an economy's productive capacity -- is evident across the U.S. Thousands of airplanes and hundreds of thousands of train cars sit unused, hotels report their highest vacancy rates in at least two decades, and millions of Americans are underemployed. How much slack there is in the U.S. economy, how fast it can be taken up and the degree to which it matters will be central to the debate when Federal Reserve officials convene this week. The Fed isn't on the verge of raising interest rates or withdrawing the huge amounts of money it has pumped into the economy, but it is debating the signals to send about how quickly it will do so. Economic Slack Underutilized industrial space, housing and workers -- the unused portion of an economy's productive capacity -- are evident across the U.S. See some of the signs of slack in the U.S. economy. View Interactive The interplay between slack and inflation is at the heart of that decision. Slack is important to their equation because, in theory, it should suppress wages and prices and keep inflation down. But if the Fed misreads the dimensions or significance of slack, it could unleash an unwelcome bout of rising prices. The risk of inflation is significant. The federal government is running budget deficits on a scale last seen during World War II, while the Fed has pumped more than $800 billion into the banking system. Banks haven't been lending this money freely so far, but once they start, it could spur economic activity and send prices rising. One signpost of gathering inflationary fears is that the price of gold, often seen as a hedge against inflation, has soared by more than 40% since last October to more than $1,000 an ounce. Inflation isn't a problem so far. Consumer prices have fallen 1.5% in the past 12 months, much of that because gasoline prices have collapsed. Excluding volatile food and energy prices, inflation is slowing: Prices have risen 1.4% in the past 12 months, by this measure, compared with a 2.5% rise over the previous 12 months. Within the Fed, there's disagreement over slack. Most officials there believe it could take years for the economy to get revving fast enough to put strong upward pressure on wages and prices. Until that happens, inflation should remain under control, and possibly fall, allowing the Fed to keep interest rates low and to concentrate on restoring growth. But some Fed officials have been arguing for months that the central bank is putting too much weight on this argument and risks being behind the curve in combating inflation. Dallas Stovall, Bright Wood's chief executive, sees both forces at work. Sales at his company, based in nearby Madras, Ore., have fallen about 50% in the past two years. Its product prices have fallen roughly 30% in the past year. Its work force, once 1,000 to 1,200 strong, is below 600 after it closed the Bend factory at the end of 2008 and made other cuts. Now its factories are operating at about 40% capacity, despite a recent four- to five-month uptick in orders. Mr. Stovall has rehired some workers, temporarily, at lower pay. He doesn't see things turning around soon -- yet his worry is that the government's response to the financial crisis will unleash rising prices. "With the amount of debt and the amount of money we're printing, the only thing that can happen is inflation," he says. "It happens every time." Economists have long debated what causes inflation. In the long run, if the Fed pumps too much money into the economy, it can drive prices higher if the economy takes off. But many other factors play a role in the short term, including swings in commodity prices and the amount of fallow production capacity. It also depends on the expectations of individuals like Mr. Stovall: If businesses and workers expect more inflation, the theory goes, they start demanding wage and price increases and set off the inflation they fear. Right now, the economy is swimming in spare capacity. Hotel occupancy rates were 56% on average this year through July, according to Smith Travel Research, the lowest since the firm started keeping records in 1987. Analysts at Credit Suisse estimate 2,535 Boeing and Airbus aircraft world-wide were in storage in July -- 14.2% of the world's fleet of these planes, a percentage that rivals the months after Sept. 11, 2001. The Association of American Railroads counts 501,472 freight cars stuck in storage at the beginning of September, roughly one-third of the nation's total fleet. In housing, 18.7 million homes were vacant in the second quarter, up from 15.9 million four years ago, according to the Census Bureau. Vacancies in shopping malls and office buildings also are up. In August, 14.9 million Americans were unemployed. Millions more were working part-time but wanted full-time work or said they would return to the labor force if there were jobs. All told, the Labor Department counts 26.3 million workers as underutilized, an increase of 13.2 million from two years ago. Soaring unemployment gives workers less power to demand higher wages. The cost of wages and benefits for private-sector workers was up 1.5% in the second quarter from a year earlier, a sharp slowdown from increases of more than 3.5% seen much of this decade. "The theory of slack affecting inflation -- you are just seeing it in spades in wage growth, which has been plummeting," Janet Yellen, president of the Federal Reserve Bank of San Francisco, said in an interview in early September. An improving economy is absorbing some of the slack. The Fed estimates factories were operating at 66.6% of their capacity in August, up from 66.1% in July, but far below the 79% average over the past quarter-century. Numbers of excess railcars and vacant homes have also inched down. In all, the Fed's internal models of the economy show, the U.S. could be producing roughly $1.2 trillion more in goods and services than it is producing without straining its resources. When supply outstrips demand, prices tend to fall. Ms. Yellen figures inflation could fall from its already low levels, a view that prevails at the Fed. But the sentiment isn't universal there. Federal Reserve Bank of St. Louis President James Bullard, a voting member of the Fed's policy-making Federal Open Market Committee, spoke out at the Fed's last meeting against putting too much weight on the economy's spare capacity as an inflation-damping force. Economists, Mr. Bullard notes, have badly misread the degree and importance of slack in the economy in the past. In the 1970s, the Fed bet that high unemployment meant inflation would fall. Instead, it rose: The productivity of the nation's work force was slowing, resulting in a need for more workers that created unexpected inflationary pressure. Then in the 1990s, when unemployment hit post-World War II lows, inflation didn't take off as some models suggested would happen. Many economists argued that the relationship between unemployment and inflation was dead. "I don't want to bet the future of the country on these tenuous statistical relationships and on a theory that was really pretty badly discredited in past U.S. history," Mr. Bullard said in an early September interview. Mr. Bullard argues that expectations of future inflation are a more important indicator of inflation's near-term direction. Consumers' inflation expectations, he notes, haven't fallen much. And, among some others at the Fed, he also argues that the conventional measures of slack are misleading. Some of the idle capacity won't be available -- decayed vacant houses, obsolete factories -- if demand revives, and thus may not help restrain rising prices, he says. In Bend, even as the local economy begins to firm up, inflation still seems a remote possibility. The town, a longtime haven for hikers and golfers in the summer and skiers in the winter, had just over 50,000 residents in 2000. Since then, a housing boom and thriving economy propelled the city to a population of more than 80,000. Ashley Willard, a 25-year-old Bend resident, is a casualty of the town's slack labor market. Her temporary teaching position wasn't renewed because of budget cuts. If a part-time kindergarten position doesn't open up this year, as she hopes, Mrs. Willard plans to live off unemployment benefits, substitute teaching and her husband's income as the operations manager at a vacation-rental company. Mrs. Willard, 25, says she no longer shops for clothes. She keeps an eye out for sales on staples like meat. "I'll buy groceries for the whole week so I don't run out and have an excuse to say, 'Oh, let's go out to eat,'" she says. On a recent shopping trip, her cart was stacked with discounted frozen meals. In surrounding Deschutes County, the housing market has been flooded with foreclosed homes, another form of slack that can put downward pressure on prices and wages. The number of default notices was more than 325% higher by mid-September of this year than in all of 2007. More than half of the homes that had been sold by mid-August were either short-sales -- in which owners sold them for less than the value of their mortgages -- or bank-owned, said Norma DuBois, a broker for Coldwell Banker Morris Real Estate in Bend. Rents are down, too, with homes intended for sale now competing on the rental market. One wild card in the inflation outlook here is the behavior of banks. Nationwide, banks have largely avoided lending the hundreds of billions of dollars the Fed has pumped into the system. Loans and leases on bank balance sheets are down 5% since the beginning of the year. Instead, these institutions are stocking up on safe Treasury bonds, or leaving extra money on deposit at the Fed. At the Bank of the Cascades -- Bend's largest locally based bank, with $2.4 billion in assets -- total loans and leases are down 14% from a year ago. Its holdings of government securities and debt issued by government-backed lenders Fannie Mae and Freddie Mac are rising. In August, the Federal Deposit Insurance Corp. ordered Bank of the Cascades to improve its capital and liquidity, an indication the bank won't be flooding the local economy with cash anytime soon. The bank didn't respond to requests for comment. Around town, while the economy has pulled back from the edge, businesses are showing aversion to raising prices or spending more. At downtown music shop Ranch Records, sales are down about 20% from last year . When the rent was set to go up 3% at the beginning of the year, the standard annual increase per their lease, store owner John Schroeder tried to get his landlord to negotiate. "He says he's pretty tight too, so he can't really budge," Mr. Schroeder said. So Mr. Schroeder said he may take advantage of cheaper spaces just blocks away. Traditionally the retail vacancy rate here has hovered around 5% to 6%. It was 13.2% at the end of the second quarter. Larry Snyder, the president and chief executive officer of High Desert Bank in Bend, says demand for loans is weak. "The dentist office that's thinking of expanding and adding another dental chair is holding off," he says. From groceries to home prices to wages, costs haven't shown any hints of rising. And inflation? "I don't see it on the horizon whatsoever," Mr. Snyder says. Write to Sara Murray at sara.murray@wsj.com and Jon Hilsenrath at jon.hilsenrath@wsj.com