Investors Underestimating the Economy and the Fed
This economic expansion has long been derided as the weakest, most disappointing ever, a characterization that is both fair and highly misleading. The expansion is weak compared with prior expansions, but it is also quite solid relative to how fast the economy is capable of growing. Understanding that relationship is the key to understanding why interest rates are likely to rise at least as quickly as suggested by Federal Reserve officials, which is faster than is currently priced into the market.
Describing the expansion as weak implies that faster growth is feasible and desirable. That’s incorrect. If growth were meaningfully stronger, the unemployment rate would be even lower, which would push inflation and interest rates higher, force the Fed to increase borrowing costs more than expected and risk terminating the expansion early. It is far better to have an expansion that is sustainable longer-term.
First-quarter gross domestic product growth is being estimated at around 0.5 percent, raising concern that the economic expansion remains disappointingly weak and might be faltering. In fact, economic growth has averaged right around 2 percent for much of the expansion, which must be acknowledged as one of the lowest rates of recovery ever from a recession. Similarly, job growth has also been below historical averages. In the past, monthly payroll gains of 300,000 or even 400,000 were common, especially at the onset of an economic recovery from recession. That has not been the case this time around.
Yet, we may be using the wrong benchmarks when comparing this expansion to the past. The moderate pace of growth has been more than sufficient to reduce unemployment at a solid pace, because labor force growth and potential GDP growth have both declined significantly. The correct benchmark for judging the pace of any expansion should be the economy’s potential for growth. Relative to that benchmark, growth has been quite good. An extreme version of this perspective can be seen in Japan, where the population and workforce are shrinking, so even 1 percent growth would represent a solid expansion of their economy and healthy gains in living standards. If U.S. growth is really so weak, then how did the standard U-3 unemployment rate decline from 10 percent to 4.5 percent?
The decline in the unemployment rate has spawned all manner of measurement questions. Are we really measuring unemployment correctly? Some argue that many people are still not employed, as revealed by the broader measure of unemployment, U-6, which counts as unemployed those who are only marginally attached to the workforce and those working part-time who would prefer full time employment. It does not matter whether one uses the U-3 (the standard measure) or the U-6 (the broadest measure) of unemployment to gauge the economy’s performance. Both (and all the other measures) are highly correlated and indicate a dramatic decline in unemployment since the recovery started in 2009.
Every measure of unemployment is at or near historical cyclical low points for that measure. It is highly deceptive to suggest the U-3 is inaccurate and that the truth is really something closer to the U-6 when that measure has also declined close to previous cyclical lows, and that’s why the economy is really performing poorly. By this logic, if we asked workers if they would prefer a better paid job, we might be able to classify 100 percent of the workforce as unemployed.
Some use the large decline in the ratio of employment to population to claim that the economy is still sick. In doing so, they ignore, either intentionally or incompetently, that the vast number of baby boomers have reached retirement age and ever more young people are getting more schooling, thereby deferring entry into the workforce. The best argument in support of underemployment focuses on “prime aged” adults between 25 and 54, where the ratio of employed to population has also declined. Indeed, there is a real problem evident in this data, but it’s more of a social issue than a failure of the economic recovery. People not working due to disability, a history of incarceration or illness has curtailed job activity for many. Running the economy hot will not solve problems that are best addressed by better medical assistance or policies to reintegrate these people into society.
What does this all mean for monetary policy? The appropriate stance depends critically on which perspective on growth is correct, whether it is more useful to think of growth as weak or if it is more appropriate to recognize that the pace of expansion has been strong enough to tighten up labor markets to the point that labor is now scarce. If growth really were weak, then monetary policy could afford to normalize interest rates gradually over quite an extended period of time. But while growth has been weaker than in the past, it is not weak relative to its potential. By every measure that we have, from unemployment claims to job openings to payroll hiring right across the board, the labor market has tightened, which is precisely why the Fed remains on course to hike rates at its June meeting and once more in 2017. Therefore, policy rates are likely to rise at least as quickly as suggested by Fed officials, which is faster than is currently priced into the market.
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