For all the guff the Federal Reserve takes from critics, several things are clear to Bank of America Merrill Lynch economist Ethan S. Harris – it avoided post-bubble mistakes made elsewhere, namely Japan. Now the U.S. economy has some positive trends to build on such as budding job growth, no near-term inflation and a patient Federal Reserve. Here is the brightening economic picture.

The U.S. economy is like the victim of a major accident.

Extraordinary policy actions have moved the economy out of the emergency room but a long period of rehab lies ahead. In the second half of this year, we expect the rehabilitation to continue with 3 percent-plus gross domestic product (GDP) growth, a slow drop in the unemployment rate and a gradual healing of the banking and housing sectors. Despite the pick-up in growth, we believe abundant spare capacity will put ongoing downward pressure on inflation and the Federal Reserve Board will wait to see clear signs of sustained healing before hiking rates next year.

Japanese lessons

The financial crisis has left the U.S. economy with some very deep wounds. The home foreclosure process is likely to continue to play out over the next several years, preventing a real recovery in the housing market. Banks are saddled with record levels of bad debt. Consumers are rebuilding their damaged balance sheets. State and local governments face a long period of budget cuts. No wonder our clients ask: is the United States headed down the same path as Japan, with its “lost decade” of stagnation?

The answer is no. Japan showed just how devastating the popping of asset bubbles can be, but it also taught policymakers how to respond to a bubble. Policymakers learned two lessons. First, act decisively. It took the Bank of Japan four years to cut its interest rate to 1 percent, another four years to cut it to zero and then two years to adopt unconventional policy. By contrast, the Federal Reserve did the whole thing in a year and a half.

The second lesson is even more important – finish the job. Japanese policymakers backed off from super-easy policy every time the economy showed signs of life (Figure 1). This is a bit like giving antibiotics to a patient and then stopping at the first sign of improvement. Japan was saddled with zombie banks for almost a decade and now suffers chronic deflation. By contrast, the Federal Reserve is engineering a rapid recovery in the banking system by keeping the yield curve very steep and is doing all it can to foster a similar recovery in the housing and labor markets.

In reality, the Federal Reserve will hike rates only when it is comfortable that a self-sustaining recovery is underway.

After nine months, labor begins

The key to growth in the year ahead is that the policy stimulus is beginning to work its way into the labor market. There are three reasons to expect solid job growth in the year ahead. First, leading indicators of employment have been trending up for a number of months, including the work week, the household survey measure of employment and temporary employment.

Second, many firms over-reacted to the recession, believing forecasts of Great Depression 2.0. For example, over the last eight quarters, non-farm businesses cut hours worked by 9.4 percent even though output was down only 1.9 percent. Some of these workers should be hired back in the months ahead. Third, the “productivity miracle” of the last two years has not been achieved through investment but by simply speeding up the assembly line. That is not a sustainable source of growth.

We believe job growth will gradually accelerate, with private payrolls rising by 280,000 per month by year end. In our view, this is a key to sustaining the economy as fiscal policy starts to tighten next year.

Inflated fears

What makes this extraordinary policy support possible is the ongoing weakness of inflation. One of the most regular features of the U.S. business cycle is that core inflation – that is, excluding food and energy – falls for several years after recessions (Figure 2). Inflation falls regardless of the speed of the recovery – often GDP growth runs 6 percent or higher early in recoveries. It falls regardless of how easy monetary policy is – the real funds rate is often negative. And it falls regardless of what is happening to the dollar or commodity prices.

The reason inflation falls after recession is simple: the economy has plenty of spare capacity. Today, after the biggest recession in modern history, the spare capacity is very big. The unemployment rate is at least 3 percentage points above its inflation-neutral level. Industrial capacity utilization is at least 5 percentage points below normal. And apartment and single-family vacancy rates are near record levels. Moreover, most of the world faces similar spare capacity. This is why virtually every measure of core inflation – as measured by prices or wages – has fallen significantly in the last year (Figure 3).

Fed fakes

Who says history does not repeat itself? After each of the last two recessions, the Federal Reserve waited more than two years before hiking rates. And yet in each case, once the recession ended, the markets and many economists continually expected Federal Reserve rate hikes were just around the corner.

This is happening again today. Every time the Federal Reserve makes a technical policy adjustment, tests a reserve draining facility or makes a minor word change, a chorus of Fed watchers warns that rate hikes could be looming.

In reality, the Federal Reserve will hike rates only when it is comfortable that a self-sustaining recovery is underway. That means waiting for significant improvement in the job market, the banking industry and housing. In the last two tightening cycles, the Federal Reserve waited until well after the recession – with a steadily dropping unemployment rate – before hiking (Figure 4). It also means waiting to see if there is a premature tightening of fiscal policy after the election. We see the Federal Reserve on hold into 2011, the first rate increase unlikely before the March policy meeting.

Give me chastity and continence, but not yet

The biggest medium-term risk to the outlook is a fiscal accident at the start of 2011. The Bush tax cuts expire at year end, and Congressional candidates will likely campaign on a platform of fiscal consolidation. Thus, while we have faith that the Federal Reserve will time its exit appropriately, we are a lot less confident about the rest of Washington, D.C. The United States needs serious fiscal consolidation, but only when the private sector is back to normal health.

So, as of mid-May, we look for a relatively sunny outlook in the coming months, but watch out for a fiscal cold front after November.

Ethan S. Harris is Head of North American Economics at Bank of America Merrill Lynch. Forecasts are subject to change.