Beware of the Fed’s outlook for long-term US GDP

After wondering for years about the slow recovery in the United States after the recession of 2007-2009, the Federal Reserve had to do the math at their September 2016 meeting.

Due to low productivity and an aging population, typical US economic growth of the 2.5% or more annual “it was no longer possible” on a sustained basis, said John Williams, the current New York Fed president, who at the time was head of the San Francisco Fed, according to transcripts of a session in which policymakers lowered their median forecast for growth of the GDP in the long run 1.8%continuing a decline of about a decade.

Over the three years since, and continuing after a world-altering pandemic, the United States has overcome that apparent limitation, growing above the 1.8% in 21 of the 28 quarters since then, including a period of annual growth of 2.5% in the years between that 2016 Fed meeting and the start of the coronavirus pandemic and with an average of 3% until now under the presidency of Joe Biden.

The pandemic, with its massive setback to growth in two of those quarters in 2020 and the multi-trillion dollar government response that followed, clouds understanding of emerging trends.

Yet when monetary leaders gather this week in Jackson Hole, Wyoming, for an annual Federal Reserve research symposium that will focus on “structural changes” they will have to deal with a profoundly changing economy, from better-than-expected growth in the US workforce, increased construction in the manufacturing sector, changing global supply chains, persistent inflation high and, now, signs of improvement in productivity.

It is unlikely that they will abandon their pessimistic view of the economic potential of the United States. Slowing population growth is a constant in the US outlook, immigration remains a politically controversial issue, and productivity gains, the other key driver of growth, are hard to predict.

Economists at investment firm BlackRock this month took an even tougher view of what they see as a “full employment stagnation”with potential growth in the United States as low as the 1% As the generation retires baby boomerwhile inflation remains volatile and labor shortages persist.

However, monetary policymakers have been surprised enough in recent years to spark a broader conversation, supported by technical analysis that assesses whether, for example, underlying interest rates have moved higher, as well as as in the fact that people continue to behave differently from what experts predict.

From September 2016 to 2019, for example, the American working population grew roughly twice as fast as the dying 0.5% that Fed staff saw as the likely trend, a steady pace once the number of available workers rebounded in 2022 from a pandemic-fuelled slide to its previous high.

“The ability to attract people into the workforce (…) was much greater than even advocates thought,” said Adam Posen, former chief monetary officer at the Bank of England and current president of the Peterson Institute for International Economics in Washington. In his opinion, the misinterpretation of the issue by the US central bank is “a major flaw” that can cloud the analysis of the situation of the economy.

Is it mostly fiscal?

For available workers to add to economic output, however, they have to have something to do. Since 2016, the vastly different actions of the Trump and Biden administrations have combined in a kind of accidental complementarity to keep both employment and economic growth above the Fed’s estimate of potential.

Under former President Donald Trump, corporate tax cuts and other changes boosted growth in ways that surprised the central bank, while under his successor, President Joe Biden, a series of industry regulations related to energy and technology , with infrastructure spending also on the horizon, has triggered a rebound in manufacturing construction.

Both presidents implemented pandemic recovery programs that may still be boosting consumer and local government spending.

Trump’s pre-pandemic years ended with the unemployment rate in the 3.5% in February 2020 and has essentially been at that level since March 2022 under Biden, while the economy is still adding roughly 200,000 jobs per month.

It’s not sustainable, said Dana Peterson, chief economist at the Conference Board think tank. Driven by the state’s fiscal and spending policies, the run of above-potential growth doesn’t reflect any underlying change in economic performance — at least not yet — and now faces two hurdles, she said.

One is the increase in public debt. While some of the money borrowed in recent years could improve economic outcomes with infrastructure upgrades or other projects, Peterson said the net result is likely a drag on growth and private investment.

The other is the Federal Reserve. The central bank is dealing with a bout of high inflation, largely related to the pandemic and the response to it, with high interest rates designed precisely to force below-trend economic growth.

Fed Chairman Jerome Powell is scheduled to speak at the Jackson Hole conference on Friday.

The Fed has raised interest rates by 5.25 percentage points since March 2022 in its bid to tame the spike in inflation, but has so far not seen as much of a response from the economy as expected. US production grew at an annual rate of 2.4% in the second quarter and could be set for a strong third quarter as well.

Although many economists believe a slowdown is in the offing, the longer growth remains robust, the more the Federal Reserve will need to lean on the economy.

The median of the Fed’s monetary policymakers’ projections of potential US economic growth has fallen from a level around 2.5% a decade ago 1.8% in June 2023, when the latest projections were released.

“In the next six to 12 months there is likely to be a recession and that is the Fed’s job”said Peterson of the Conference Board. “After that we will move into a phase of slower growth.”

New productivity regime?

An alternative view harkens back to former Federal Reserve Chairman Alan Greenspan’s hunch in the mid-1990s that accelerating economic growth stemmed from technological improvements that paved the way for workers to produce more per hour, which allowed the economy to grow faster without increasing inflation. Under pressure from his colleagues to raise interest rates as the economy accelerated, Greenspan resisted, accommodating expansion rather than fighting it.

At the start of the pandemic, some economists suggested that changes in the application of technology or the move to remote work could boost worker output.

At last year’s Jackson Hole conference, San Francisco Federal Reserve economist and productivity expert John Fernald and his colleague Huiyu Li said in a paper that while the pandemic had reordered some industry trends, it had not changed the world. “slow growth regime” underlying, in which productivity increased by about a 1.1% year. On the contrary, productivity increased by around 2.5% yearly between 1995 and 2005.

However, productivity increased a 3.7% annualized in the second quarter of this year and expectations of strong momentum in the current three-month period “they offer glimmers of hope that the productivity trend is picking up”wrote Michael Feroli, chief US economist at JPMorgan, this month. He concluded that the change “could have some run-in,” with increased investment in software and information processing possibly pointing to the spread of artificial intelligence applications.

The Federal Reserve may not care much as inflation remains high. But it could help economic growth continue despite slowing prices, another mainstay for the “soft landing” that the Federal Reserve hopes to design and possible proof of rising potential.

“It is very difficult to extrapolate the last few years to any reassessment of longer-term conditions”said Antulio Bomfim, head of global macroeconomics for Northern Trust Asset Management’s global fixed income group and a former senior adviser to Powell. But “that being said, (…) I would see the balance of risks on the upside,” he added.

Source: Reuters