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?