The Economy May Be Set for a Supply-Side Surprise
Will 2018 be the year the supply side of the economy roars back to life? If so, the Federal Reserve’s expectations for inflation may once again be met with disappointment. But be wary of believing this would portend a dovish year for policy. A supply-side rebound would likely trigger upward pressure on the long end of the yield curve, giving the Fed more room to raise rates.
The central bank has a pessimistic view of the economy’s fundamental capacity for growth. According to the Summary of Economic Projections, policy makers hold a median estimate of longer-run growth of just 1.8 percent. Low labor force growth and productivity account for this anemic number.
Policy makers anticipate growth of 2.5 percent this year, well in excess of the growth of the supply-side economy. Given that the Fed believes labor markets are already stretched to, and possibly beyond, full employment, such growth would eventually fuel inflationary pressures. To stave off that outcome, central bankers expect they need to raise interest rates 75 basis points this year. The Fed expects this pace of tightening (forecast to continue into 2019) should be sufficient to ease growth back to a more sustainable level in the longer run.
In other words, this is about as good as it gets for economic growth this cycle. It’s downhill from here.
But maybe not. In the fall of 2016, Fed Chair Janet Yellen said that running a “high-pressure economy” might help boost investment spending and revive the supply side. A tight labor market might boost labor-force participation; increase the capacity for better, more productive matching between employees and companies; and boost capital investment. Yellen posed this issue as a potential research question. She did not intend any immediate implications for monetary policy, and indeed the Fed continued with its gradual pace of rate hikes.
Still, regardless of the Fed’s intentions, it could be argued that central bankers’ growth projections indicate the stage is set for a high-pressure economy in 2018. In other words, this year may be a test of Yellen’s hypothesis, even if unintended.
If the Fed’s current estimates of potential growth are a hard limit, then we should see more evidence the economy is hitting supply-side constraints this year. Most notably, this would include faster nominal wage growth and inflation. Indeed, if the central bank's growth projections hold, I would expect a greater upside risk to inflation and with it the possibility that the Fed hikes rates faster than anticipated.
But if running a high-pressure economy stimulates the supply side, we might expect a further acceleration in capital investment that not only charges the demand side of the economy, but accelerates productivity growth, too. This could boost not just nominal wage growth, but also real wage growth as inflation would remain contained. Moreover, faster wage growth might also induce greater labor-force participation, allowing the economy to maintain a fairly rapid pace of wage growth. In addition, we might expect continued solid sales growth and high margins in such an environment -- a recipe for higher equity prices.
What would such an outcome mean for monetary policy? There will be a tendency to think the Fed could ease up on the pace of rate hikes. There is reason to be wary of such thinking. Instead. I would anticipate that a faster pace of potential growth would boost the real neutral interest rate, in turn putting upward pressure on the Fed’s estimate of their terminal federal funds rate. This would mean that policy would be more accommodative than the Fed currently anticipates, even holding its current rate forecast steady. Note also the related possibility of an upward shift of the yield curve to shift rather the flattening of the curve since the rate hike cycle began.
For now, I am sticking with the story that the relative stability of the long end of the yield curve since the Fed began hiking rates indicates it has less room to raise the federal funds rate than policy makers believe. Still, I am watching for factors that might change that story, and a supply-side rebound is at the top of that list.
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