updated 11/19/2003 2:46:50 AM ET 2003-11-19T07:46:50

The economy is cooking. Business spending is rising and the job market has turned up. The pickup in growth, in the U.S. and abroad, has sent commodity prices soaring and fanned fears of a resurgence of inflation. The central banks of Australia and Britain have already raised interest rates, and the U.S. bond market figures the Federal Reserve will follow suit early next year.

Don't count on it. Although economic growth hit a staggering 7.2% in the third quarter and is expected to settle in at a zippy 4% over the next few quarters, Fed Chairman Alan Greenspan and his cohorts believe they can take their time before raising rates. Despite investors' skepticism, Fed insiders believe the U.S. is in a unique period where inflation is so low -- and the economy still boasts so much slack -- that they can relax and let things rip. "In these circumstances," Greenspan said on Nov. 6, "monetary policy is able to be more patient."

THAT'S A BIG SHIFT from past recoveries. Generally, the Fed has felt compelled to raise rates early in the cycle because it believed inflation was too high and needed to be contained. Not this time. Excluding volatile food and energy costs, consumer prices in September stood just 1.2% higher than a year earlier. Contrast that to the nearly 3% core inflation rate that prevailed in February, 1994, when the Fed began hiking rates in the last cycle. Some Fed officials might even be willing to wait to tighten until inflation ticks up and moves the economy well clear of the deflationary danger zone.

BECAUSE OF EXCESS CAPACITY and elevated unemployment -- what economists call the output gap -- plenty of slack still remains in the economy. According to output-gap theorists, the recession of '01 and the slow recovery since have left the economy some 2% smaller than it would have been had it stayed on its long-term growth trend. Until that growth deficit disappears, the theory goes, inflation pressures will be muted. In fact, some at the Fed, including Governor Ben S. Bernanke, fear the gap will put unwelcome downward pressure on inflation in 2004.

The only way to get rid of that gap, Bernanke and others believe, is to turbocharge the economy by running it in excess of its long-run cruising speed. If, as many Fed policymakers believe, the trend growth rate of the economy is 3 1/2%, then it needs to grow 5 1/2% next year to close the gap.

To be sure, there are risks to the Fed's strategy. As Greenspan is well aware, the output gap is an ephemeral concept at best. Indeed, Fed research found that estimates of the gap often are badly off the mark and can lead to policy mistakes. What's more, if the Fed holds off too long on hiking rates next year, it faces the politically difficult choice of raising them too close to the November, 2004, Presidential election. Still, with inflation low and the jobs recovery just begun, Greenspan seems willing to err on the side of ease for now.

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