New figures show that the speed at which America’s economy can grow without stoking inflation has fallen
Jul 19th 2014 | WASHINGTON, DC | From the print edition
AMERICAN workers have had no news this good for years. In June employers added 288,000 jobs, bringing the total for the year to 1.4m, the best six-month stretch since 2006. Unemployment has sunk to 6.1%, the lowest rate in almost six years. It could hit levels long regarded as “full employment” within a year. Help-wanted signs are proliferating, with vacancies up by 20% since January.
Such an ebullient labour market is usually the token of a booming economy. Not now. In the first quarter gross domestic product fell by 2.9% at an annual rate, the worst showing since the recession. This was a result in part of bad weather. Yet the second quarter will only be strong enough to make up the ground lost in the first. Economists had thought 2014 would be the best year since the recession; with growth in the first half of around zero, it is shaping up to be the worst.
Economic growth over the business cycle is driven mostly by swings in demand, and in recent years demand has been held back: households have been repaying their debts; the government has restrained its spending and raised taxes; and interest rates, having reached zero, are unable to fall further. Over the long run, however, a country’s potential growth depends on supply: how many workers it has and how productive they are. The recent divergence between America’s employment and output suggests the country faces not just deficient demand but also enfeebled supply, as more people working without more output means lower productivity. That is bad news for all Americans since their standard of living depends on productivity. It is also a headache for the Federal Reserve, since inflation emerges more quickly when economic capacity is expanding more slowly. Thus it could mean interest rates rising sooner than might otherwise be expected. If so, though, it would also mean they might not rise that high; in a slower-growing economy, there is less demand for capital.
In the 1990s America boasted one of the rich world’s highest potential growth rates, of more than 3%, thanks to a labour force that was expanding by more than 1% a year and productivity, fuelled by the spread of information technology, growing at around 3% a year (see chart 1). By 2007 the Congressional Budget Office (CBO) had trimmed its estimate of potential growth to a still respectable 2.6%. It now thinks it may be just 2.1% (see chart 2). The Fed has lowered its projections of long-term growth by almost as much.
Even that may be optimistic. The recent spell of strong jobs growth and feeble output means that productivity declined by 0.4% over the past year, JPMorgan calculates. The labour force did not grow at all. Economic theory holds that unemployment declines when the economy grows faster than its potential on the upswing of the business cycle. If the slow growth of the past year was above the long-term potential, as the rapid drop in unemployment suggests, it would seem to imply that the long-term potential was actually negative. Things are almost certainly not that bad. Still, JPMorgan reckons America’s potential growth is just 1.75%—about half the rate it enjoyed from 1947 to 2007.
Measuring potential growth is notoriously difficult. Productivity is volatile, making underlying trends hard to discern. Disentangling short-term demand from long-term supply is complicated by the fact that the former has a direct effect on the latter. When the economy is booming, businesses invest and innovate more, which raises productivity, and people who might have stayed at home, retired or remained in school join the labour force. That is what happened in the 1990s: as the economic boom continued with no uptick in inflation, economists concluded that potential growth had risen.
The great reversion
The optimistic way to read the current situation is as the same thing happening in reverse: potential growth may be being depressed by the hangover of weak demand from the Great Recession, rather than by underlying structural forces. For example, the labour force has grown by just 0.3% per year so far this decade, compared with 0.8% in the previous decade, and the participation rate—the share of the working-age population either working or looking for work—has fallen from 65.9% at the end of 2007 to 62.8%. Some of that is structural: of particular note is the fact that the first baby boomers qualified for Social Security (the public pension) in 2008. Some is cyclical: those who have not found work since the recession are quitting the jobs market. But which effect is bigger?
A new report by Barack Obama’s Council of Economic Advisers reckons 1.6 percentage points of the 3.1-point decline in participation can be explained by ageing alone. It reckons another half point is clearly cyclical. That leaves a gap of roughly one percentage point requiring explanation. One factor is that 16- to 24-year-olds are staying in education longer, and are less likely to work while learning. But participation among those aged from 25 and 54, the biggest and most active portion of the workforce, has also fallen—and it was doing so before the recession hit.
This fall has been most striking for those with less education: participation has dropped by four percentage points for those with only a high-school diploma, according to Judd Cramer, a doctoral student at Princeton University. These are the workers most likely to be displaced by technology or foreign competition. But this long-standing trend was made worse by the recession; participation in states hit harder by the recession fell more than it did in those less afflicted, according to Christopher Erceg and Andrew Levin of the International Monetary Fund.
In theory, a hotter economy should draw some of these workers back into the labour market. In practice, the impact is likely to be small. Many dropouts have retired or begun collecting disability benefits, a decision that is “more or less permanent”, according to Shigeru Fujita of the Federal Reserve Bank of Philadelphia. And the structural problem will get worse; the baby-boomers will continue to retire, even as the supply of new workers shrivels. The Census Bureau reckons America’s working-age population will grow by just 0.3% a year from 2010 to 2030, less than a third of the rate of the past two decades. Ageing is not the only reason: falling fertility rates and declining immigration also play a role.
Like labour, productivity is growing more slowly, averaging a little over 1% since the recovery began, about half the average of 2.3% from 1947 to 2007. This might be partly cyclical: weak sales and financial crises have discouraged investment in recent years. But productivity growth had begun to slow even before the recession, from around 2005. John Fernald of the Federal Reserve Bank of San Francisco attributes this to the waning of the IT revolution. Led by the likes of Walmart, a fiercely efficient retailer, businesses began using IT in the late 1990s to better manage supply chains, deploy workers and design products. By 2005 they had reaped most of the benefits, the theory runs, and the pace of innovation in semiconductors had slowed.
The spread of social media which allow new forms of working, of automation which increases an individual’s output and of many other technological innovations which, like those of the previous wave, are taking their time to show up in the productivity figures may yet improve the outlook. But such a pay-off could be many years away. As Michael Feroli of JPMorgan notes, the share of GDP devoted to investments in IT plunged during the recession and has continued to fall, even as investment of other sorts has recovered. The Bank Credit Analyst, an investment journal, notes that lower potential growth means business needs less capital to meet future sales. That would explain why investment, at 12% of GDP, remains below its pre-recession peak.
Even if potential growth picks up a bit, America will increasingly resemble the ageing slow-growth economies on which it used to look down. To improve potential growth policymakers can take various steps, such as raising the age at which the elderly receive government benefits, lowering the top corporate-tax rate and reforming support for the disabled. But such steps would take years to bear fruit. In the meantime the Fed has held interest rates at zero out of a belief that the economy is loaded with spare capacity which is holding down inflation.
Recent data have prompted a reappraisal. Not only has unemployment fallen rapidly, broader measures of underemployment which include the unemployed who have given up looking for work have fallen even further. Yet participation has not risen. Meanwhile, employers are having more trouble filling jobs: in May 3.2% of all jobs went vacant, close to a seven-year high, suggesting the jobless lack the skills that employers are looking for.
All this indicates that the economy is closer to full employment than the Fed had expected just a year ago. Given how quiescent wages and prices remain, rate rises seem still at least a year away. But as Janet Yellen, the Fed chair, noted on July 15th, that date will come sooner if unemployment keeps falling so quickly.
The original article is linked here.
Jul 5th 2014 | From the print edition
FOR most of its 80 years, America’s Export-Import Bank has laboured in obscurity, providing loans, loan guarantees and credit insurance to foreign buyers of American products from jumbo jets to quiche. All of a sudden, it is in the spotlight: Tea Party conservatives have declared it to be the embodiment of corporate welfare. Republicans are threatening to block reauthorisation of the bank when its mandate expires on September 30th.
The fight over ExIm has drawn rare attention to one of the most pervasive and enduring instruments of mercantilism in the world trading system. Export-credit agencies got their start early last century. Britain’s, established in 1919, was part of an effort to improve its balance of payments and thus return to the gold standard. America’s ExIm Bank was originally conceived as an instrument of foreign policy, to provide leverage over the Soviet Union and support for Cuba.
The global financial crisis gave such banks a new lease of life. When banks pulled back from trade finance after Lehman Brothers collapsed in 2008, governments prodded their export agencies to fill the gap to prevent a bigger fall in trade volumes. Official export credit extended by the G7 alone soared from $35 billion in 2007 to $64 billion in 2009, and has remained around those levels since (see chart below).
Subsidised loans for exports have long been recognised as a form of mercantilism, which is why rich countries struck a gentlemen’s agreement in 1978 to curb them. Signatories to the “OECD arrangement” agree to maximum loan maturities, commercially-based interest rates and minimum risk premiums for insurance. When one signatory strikes a financing deal, it notifies the others, giving them the opportunity to match the terms. Read the rest of this entry »
Jul 5th 2014 | WASHINGTON, DC | From the print edition
IAN TONER, an architect in Philadelphia, recently went to city offices for a permit to build a stoop for a client’s home. The city, he learned, had just imposed new requirements: he would have to get maps from gas, electric, water and other utilities to ensure the stoop would not disturb their underground lines and then resubmit his application. A process he thought would take a day took more than two weeks.
That’s not all. Other new rules require that he prove that his builder has general liability, workers’ compensation and car insurance, and has paid all his taxes. Four times a year he must set aside a half day to ensure he is paying the state’s and city’s myriad taxes correctly. Mr Toner doesn’t question the need for rules and taxes; what galls him is the time and hassle involved in complying with them. “The information exists all over the place and the burden is on me not just to gather it but [to] interpret it. I’m not going to leave here because of this, but they’re all things that could turn a person off of coming here.”
America’s states and cities have traditionally tried to attract businesses by offering them tax breaks and other cash incentives. Yet there may be a more effective way, and one which puts no strain on stretched budgets: make life simpler. Read the rest of this entry »
Jul 2nd 2014, 20:32 by G.I. | WASHINGTON, D.C.
Janet Yellen, the Federal Reserve chair, has long said there might be times when monetary policy could be used to counteract financial instability. But in a speech before the International Monetary Fund today, she erected such a high bar to its use that is seems unlikely ever to happen: the “potential cost … is likely to be too great … at least most of the time.”
The unstated logical conclusion is that there is some optimal exposure to crisis. Read the rest of this entry »
Jun 26th 2014, 15:42 by G.I. | WASHINGTON, D.C.
First, factual. Yes, core CPI inflation has rebounded to 2% from 1.6% in February and today we learned that core PCE inflation has risen to 1.5% from 1.1%. What should we infer from this? Nothing. In the short run inflation oscillates because of idiosyncratic movements in various components, such as rent, health care and imported commodities, but over longer periods, it is remarkably inertial: the best forecast of inflation over the next five years is inflation over the past five years. The nearby chart illustrates this;
core inflation fell below 1% in 2010 and rose above 2% in 2012; neither marked the start of a new trend. There is no reason to think the recent run of high monthly readings is a new trend, either. The Fed, to its credit, didn’t freak out when core inflation was scraping 1% earlier this year; it predicted that as the downward pressure from imported goods inflation and health care faded, overall inflation would move toward its 2% target, and it has. Yes, it has done so slightly faster than expected but this is no more cause for concern than learning a patient will be discharged from the intensive care unit in six weeks instead of eight. Second, theoretical. If you have a forecast of higher inflation, it helps to have a theory of the inflation determination process behind it. Inflation is a continuous rise in the price level; the obersvation that the price level has risen recently is not a theory any more than a patient’s high temperature is a theory of infectious disease. Many critics think the prolonged period of low real rates and the large size of the Fed’s balance sheet are in and of themselves inflationary, but this is divorced from any consideration for why real rates are negative and the Fed’s balance sheet so large in the first place. Charlie Evans, president of the Federal Reserve Bank of Chicago, calls this “the spontaneous combustion theory of inflation… Households and businesses simply wake up one day and expect higher inflation is coming without any further improvement in economic fundamentals.”
There are many competing theories for the inflation determination process. What do they tell us? The New Keynesian theory, to which the Fed subscribes, considers inflation a function of slack and expectations. The evidence is pretty persuasive that while slack has shrunk in the last five years (and perhaps faster than expected because of diminished potential), it remains ample. Expectations, likewise, have oscillated but shown no trend up or down.
You may dismiss this model because slack is hard to measure and expectations are a lagging indicator. Perhaps you prefer to look at costs (as a mechanical price mark-up model does). Labour is the main component of costs, and as the nearby chart shows,
unit labour costs are up just 1.2% in the last year. This, too, is a noisy series, as it is driven by both wages and output per hour; but it’s hard to see a worrisome trend. Wages have barely kept up with prices since the recovery began which means the benefits of productivity growth (meager though they are) have gone predominantly to profit margins, which touched a new high of 12.7% in the fourth quarter. They dipped in the first quarter, but they’ll probably bounce back after GDP reverses its drop. So profit margins could accommodate some acceleration in labour costs and remain comfortably wide. What if you consider inflation always and everywhere a monetary phenomenon? I consider the money supply pretty useless for forecasting anything, but even if were a monetarist, I wouldn’t be worried. Quantitative easing has significantly expanded the monetary base, but that expansion will end once QE stops later this year. Meanwhile, this has not fueled broader measures of money and credit: M2 is up just 6.5% in the last year, slightly faster than last year but still well below rates of growth recorded in 2011 and 2012 (which, you’ll recall, did not signal an inflation breakout).
Third, strategic. I recently attended a conference at the Hoover Institution on central banking where many of the presenting scholars were deeply concerned the Federal Reserve’s unorthodox policies would lead to an eruption of inflation before long. Many cited the 1970s when the Fed kept real interest rates too low for too long in the mistaken belief the economy was operating below potential. What these analyses ignore is the asymmetry of risks facing the economy. Of course, the Fed might wait too long to tighten and inflation could eventually rise above the 2% target. But, leaving aside how costly such a deviation would be, the Fed has demonstrated it knows how to get inflation back down, even if the process can be costly. By contrast, recent history shows how few effective tools central banks have for reversing inflation that falls too far, or turns to deflation. Either outcome raises the prospect of real interest rates that are too high and unemployment above its natural rate for years to come. Given this asymmetry, overshooting inflation is clearly a lesser evil than undershooting inflation. This, more than anything else, is why the panic over inflation is misplaced.
Jun 19th 2014, 18:25 by G.I. | WASHINGTON, D.C.
Secular stagnation is a delightfully alliterative description of America’s economy, but also an ambiguous one. “Secular” implies the depressed state of the economy is down to structural, supply-side factors, whereas “stagnation” suggests cyclical obstacles to demand are to blame. The distinction matters, because it will determine the path for interest rates.
Let’s assume stagnation is the problem: the normal cyclical recovery of the economy is being smothered by headwinds to demand: deleveraging, tight credit, fiscal contraction, post-crisis risk aversion, etc. The supply side is largely unscathed. This means there’s a big gap between actual and potential output which puts significant downward pressure on inflation. In this case, the path of interest rates should resemble the blue line in the nearby chart. The Fed keeps interest rates near zero as long as possible to overcome those headwinds. The large output gap ensures this doesn’t allow inflation to emerge. But eventually, the headwinds fade, demand springs back and the Fed must quickly tighten so that by the time demand converges with supply (i.e. the output gap closes), rates are back to their natural, equilibrium rate. In this case, the natural rate is same as it was before the crisis, i.e. a nominal rate of around 4%, and a real rate around 2%.
Now suppose instead that secular, supply-side forces are the reason growth has been so disappointing. These would include diminished labour force growth because of aging, lifestyle choices, lower fertility and immigration; reduced innovation; and as a consequence of all these things, less capital investment. In this case, the right path for interest rates is shown by the red line. Because weak growth is due primarily to lower potential, the output gap is much smaller and an outbreak of inflation more of a risk. This means the Fed must start to raise interest rates sooner, and more quickly, so that they are back to normal by the time the output gap closes. But lower potential growth means the return on capital is lower which reduces the natural, or Wicksellian (named for Knut Wicksell) interest rate, and so Fed funds plateaus at a lower level.
Deciding which of the two scenarios applies requires estimating both potential growth and the natural rate of interest – no easy task since neither can be directly observed.
Thomas Laubach of the Federal Reserve Board and John Williams, now president of the Federal Reserve Bank of San Francisco, managed to do just that with an elegant, intuitive model in a 2001 paper. They define the natural rate as the rate needed to keep the output gap at zero. Then they develop a model of potential output that yields an output gap, and from that infer the natural rate. This is determined by both potential growth, and a bunch of other factors like risk aversion and desired saving. Because these latter factors move a lot over the business cycle, the natural rate fluctuates more than if only relatively-slow moving potential growth mattered. For example, Mr Williams’ updated estimates imply the real natural rate of interest was -0.2% at the end of 2013, owing both to high desired saving, and a steady decline in potential growth, to about 2% now from 2.9% in 2007.
Your choice of interest rate path thus depends heavily on how you interpret recent data. The fact that unemployment has fallen far faster than GDP can explain may be down to demand – a lot of discouraged workers have quit the labour force – and thus require zero rates for longer; or it may be because potential growth is lower, which means the output gap is closing quickly, and the Fed must start tightening relatively soon. For most of the last few years, Fed officials threw their lot in with the demand side story: they kept pushing out the date that rates would start rising. That’s changing. In the FOMC’s latest survey of economic projections, released yesterday, members lowered both expected growth and unemployment this year while trimming their estimate of potential growth to 2.2% from 2.25% (it was 2.65% in 2009). They slightly raised the path of expected hikes in the Fed funds rate while lowering its long-run level (the de facto the natural rate) to 3.75%, from 4%.
This process is probably not over; labour market and demographics factors may have depressed potential growth to below 2%. Add in high desired saving from fiscal consolidation and reserve accumulation by emerging economies, and the natural rate is probably closer to 3% than 3.75%. This also means inflation has probably bottomed out and could move back to, or even above, target within a year or so.
This doesn’t necessarily mean, however, that bond yields are about to shoot higher. That’s because the negative of a quicker liftoff by the Fed is more than offset by the positive of a lower long-run natural rate. For equities, the implications are ambiguous: a lower natural rate reduces the discount rate and raises the price-earnings ratio, but lower potential depresses earnings growth.
My analysis treats supply and demand separately. In reality, they are interrelated. People who lose their jobs for cyclical reasons and then go long enough without work can end up permanently out of the labour force. As Mr Williams and his colleague Glenn Rudebusch note in a recent paper, getting the long-term unemployed back to work can restore some of the economy’s lost potential. But it will require more stimulative monetary policy and inflation overshooting for a while. This is a prospect the Fed may have to grapple with before long. When I asked Janet Yellen about it, she indicated she was open to letting inflation overshoot if it was necessary to get unemployment down: “If the distance from achieving an objective [either full employment or low inflation] is particularly large, it would be consistent with the balanced approach that we would tolerate some movement in the opposite direction on the other objective.” She suggested that such a scenario was pretty unlikely. Hopefully, though, she’s preparing for it – just in case.
The original article is linked here.
Central banks around the world are struggling to promote growth without fomenting worrisome risk-taking
Jun 21st 2014 | Washington, DC | From the print edition
UNTIL the global financial crisis, central banks treated bubbles with benign neglect: they were hard to detect and harder to deflate, so best left alone; the mess could be mopped up after they burst. No self-respecting central bank admits to benign neglect any longer. “No one wants to live through another financial crisis,” Janet Yellen, then a candidate to head the Federal Reserve, said last year. “I would not rule out using monetary policy as a tool to address asset-price misalignments.”
After six years of interest rates near zero the tension between central banks’ responsibility for output and inflation on one hand and financial stability on the other is growing. On June 12th the Bank of England hinted it would pursue new measures to curb ever-climbing property prices. Shortly afterwards Ms Yellen fretted about the “reach for yield” and subdued volatility, a sign of investors’ complacency.
Read the rest of this entry »