Can the Fed Achieve Sustainable Growth and Quit Raising Rates?
Although the nine years of this expansion is one of the longest in U.S. history, Australia’s 27 years without a recession shows that growth cycles have far more potential than most people realize. Fears of slowing economic growth have driven financial markets lower, prompting some to believe that the Federal Reserve should stop raising interest rates. Yet to do so, the Fed must be convinced the economy will grow close to its potential without serious risk of higher inflation. That sort of balance is difficult to achieve but could add years to this cycle.
The Impact of Neutral Rates on Growth
Theoretically, there is a range of “neutral” interest rates that allow the economy to grow at or very close to potential without generating inflation. Rates below this range encourage the economy to grow faster; above that range, interest rates forcefully slow growth. If rates stabilize in the neutral range, the economic expansion should continue for an extended time.
Through the third quarter, Fed officials thought the economy was growing too fast. More recently, however, Chairman Powell acknowledged that rates seem close to the low end of the neutral range, suggesting rates may not need to increase much more.
Some economic slowing still seems needed for the Fed to pause, but with rates close to neutral, we could also be close to achieving sustainable economic growth.
Signs of Sustainable Growth
The tightness of labor markets illustrates why we still probably need to see some slowing. Economists estimate population growth can fill roughly 100,000 jobs each month without putting undue pressure on the labor markets. That much growth is clearly sustainable. A rising percentage of people participating in the workforce could provide somewhat higher growth, but probably not at recent levels. Job growth averaging close to 170,000 over the last three months suggests the economy is still drawing heavily on pools of labor that will likely run dry.
When labor is scarce, growth of the labor force and productivity improvements also limit the economy’s growth potential.
A 100,000 increase in the labor force translates to growth of approximately 0.7%
Productivity improvements should add roughly 1.3% more
Together, those figures indicate that sustainable economic growth is probably closer to 2% than the 3.5% growth we saw in the third quarter
Tight labor markets also mean that rising wages could fuel inflation. With productivity rising 1.3 percent over the last year, wages should be able to rise 3.3 percent (allowing for 2 percent inflation) without putting heavy pressure on inflation or profit margins. Although most wage gains have remained below that level, the gains have accelerated. To achieve sustainability, wage gains need to stabilize at a manageable level.
The Road Ahead
Although investors have been nervous about a slowing economy, some slowing still seems needed. With labor markets extremely tight, if the economy does not slow, the Fed will most likely raise rates until it does.
The economy is, however, already poised for a slowdown. The waning effects of the Federal tax and spending bills will slow growth in 2019 — as will the lagged effects of previous rate hikes. Growth should therefore trend in the Fed’s direction.
Ironically, the biggest challenge may be to end rate hikes before growth has slowed to a sustainable level. The full effect of rate hikes is typically not evident for approximately nine months. That means the Fed needs to stop raising rates before the economy reaches the desired level of growth.
Historically, overtightening has frequently caused recessions, but the recent turbulence in the stock, bond and oil markets seems to have convinced Fed officials that they need to proceed cautiously. If they can manage the transition to sustainable growth properly, a substantially longer expansion may be possible.
About Bruce McCain, Ph.D., CFA®
Bruce McCain is the Chief Investment Strategist for Key Private Bank, where he monitors the economy and the financial markets and serves as part of the team that formulates investment strategies for clients. He supplies frequent insights to media throughout the region and around the country. His comments and interviews have been featured in such publications as The New York Times, The Wall Street Journal, Investor’s Business Daily, and Business Week, as well as on television outlets such as CNBC and Bloomberg TV. He is also a regular source for wire services such as the Associated Press and Reuters and is a Contributor on Forbes.com.