There is an important debate now taking place among monetary policy analysts over the question of "capacity utilization." Its resolution will tell us much about the future course of the U.S. economy.

The theory is that if the economy has substantial unused capacity for production, then monetary policy can be expansive without the risk of inflation. Unused capacity in the economy would include unemployed workers and idled plant and equipment that could be used to produce goods and services if the demand was there.

For almost 3 years, the Federal Government has done everything in its power to stimulate demand by increasing the money supply, easing credit conditions, tax rebates, and a huge budget deficit. According to standard economic theory, these measures should have compensated for the lack of private demand and helped restore economic growth.

To a certain extent, growth results from restoring a degree of inflation. The theory is that huge budget surpluses and a restrictive monetary policy instituted a period of deflation--falling prices, the opposite of inflation. Purchasing power was drained from the economy, putting downward pressure on prices, which caused profits to evaporate and forced severe cost cutting, including mass layoffs and a rise in unemployment.

It is often argued that no deflation existed because the general price level, as measured by the Consumer Price Index, never fell. But this doesn't mean that monetary policy, which fundamentally determines the prices level, was not in fact deflationary. It's just that there is a long time lag before it affects the CPI. Moreover, there are many problems with how the CPI is constructed that cause it to persistently overstate inflation.

For this reason, many economists look at commodity prices and other indicators that react much faster to changing monetary conditions than the CPI. Almost all of these are signaling a turn away from deflation and toward inflation. These include a sharp increase in the price of gold, a fall of the dollar against foreign currencies, and a rise of long-term interest rates, which mainly reflect inflationary expectations, relative to short-term rates.

The Fed is now arguing that these indicators do not forecast inflation mainly because there is unused capacity. For example, on Nov. 6, Fed Governor Ben Bernanke, said this: "I believe that the current low level of inflation, the expansion of aggregate supply by means of ongoing productivity growth, and the high degree of slack in resource utilization together leave considerable scope for a continuation of the currently accommodative monetary policy without undue risk to price stability."

Last week, Michael Moskow, president of the Federal Reserve Bank of Chicago, made a similar point. "Economic output is determined by an economy's available labor and capital resources and their productivity," he said. "If actual economic output persistently lingered below its potential, which economists refer to as an output gap, inflation would decline."

Continuing, Mr. Moskow said, "In the past two years, the unemployment rate has increased and capacity utilization rates in the U.S. have declined. Both movements suggest that the level of actual output has been falling short of potential, so there is an output gap."

Translated into English, the Fed is saying that it will continue pumping up the money supply and maintaining easy credit conditions for a "considerable period," as it said in a recent statement. Its view is that the economy is like a bucket that has been partially drained. Until the bucket is full again, there cannot be inflation. Therefore, the Fed will continue stimulating demand indefinitely.

The problem with this theory is that it is not borne out by experience. In the 1970s, there was high unemployment and low capacity utilization, yet high inflation. A key reason is that labor, plant and equipment are not homogeneous. When demand is stimulated, it may require workers with different skills in different places to satisfy. Similarly, producers may not have the right equipment to make the things people want. Therefore, new investment must take place first before production can rise.

Although the Fed's capacity utilization index may be at a historical low of about 75 percent, much of that unused capacity is worthless. It is malinvestment that simply must be written off. This means that inflation could easily reemerge well before capacity hits 82 percent, generally considered the tipping point. It also means that unused capacity is no barrier to new investment.

I believe that the message of markets, which is showing signs of inflation, is a more accurate indicator of future prices than the capacity utilization index or the unemployment rate. If the Fed continues easing, it runs the risk letting the inflation genie out of the bottle. A little tightening now would be prudent, forestalling more severe tightening later.