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The Federal Reserve is poised to raise interest rates, but whether the Fed begins liftoff tomorrow or early in the New Year, the climb thereafter is likely to be gradual. Futures contracts predict a gentle ramping up of interest rates, with the federal funds rate hitting about 1.4 percent by the end of 2017 and 1.7 percent by mid-2018. If investors are right, this will be the slowest interest rate normalization on record.
The expectation that rate hikes will happen at a gradual pace reflects mixed signals about the economy. As the Fed tries to fulfill its dual mandate of stable prices and full employment, it faces low headline numbers for inflation and unemployment. But as we discuss in our report, the devil is in the details. Unemployment is already at the “natural” rate” according to Congressional Budget Office estimates, and further declines would normally spark an increase in inflation. However, inflation remains very low, usually an indication of underutilization of resources like labor and machinery. One explanation for this dichotomy is the still elevated number of involuntary part time workers and those who were unsuccessful in landing a job within the last year. And as long as there is no shortage of people willing to work at prevailing wages, inflationary pressures will remain muted.
The current six-year expansion is already longer than most, and when the US economy hits the next recession the Fed will lower interest rates again. To combat recessions in the past, the Fed has typically brought down the federal funds rate—the interest rate at which banks trade balances held at the Fed—by 3 to 4 percentage points. But if the next recession hits prior to 2019, rates may begin to decline even before they reach 2%. In other words, for the foreseeable future the trajectory of the federal funds rate is likely to remain in the low single digits.
What about market interest rates that affect businesses and homeowners? The onset of monetary tightening will almost certainly nudge rates on business loans and mortgages somewhat higher. But if history is any indication, these rates will rise by less than the federal funds rate, with the spread between them tightening due to lower borrower default risk during an economic expansion.
The economic rebound from the bottom of the Great Recession was less vigorous than post-recession rallies of the past. Notwithstanding some recent pickup of momentum in the US, output growth in developed countries has continued to remain relatively subdued. But should we expect to see any faster growth going forward? Two prominent economists, John Fernald* and Robert Gordon**, point to demographic changes and declining productivity as the limiting factors behind the economy’s lower growth potential.
Most rich countries are facing a handicap due to their stagnant and aging populations. With the ongoing retirement of baby-boomers, the declining labor-force participation rate creates a drag on potential growth. Some of these headwinds have been counterbalanced by growing employment, but faster economic growth would require an unlikely acceleration of labor market improvement. In other words, labor force participation would have to strengthen, or the unemployment rate, which has been falling roughly one percent per year in the US, would have to decline even faster, from 5.6% in December, 2014 to 3.0 percent or below by 2017!
Annual productivity growth, another component of economic expansions, has averaged 0.5% since the recovery started and 1.2% over the past decade in the US. These values are far below the temporary, informationtechnology- fueled pace seen in the mid-1990s and early 2000s. An increase in productivity growth requires an increase in the pace of innovation. So once the main breakthroughs of the IT revolution were fully incorporated into creative processes, they stopped stimulating a further surge in productivity. There were other drivers of exceptional growth earlier in the twentieth century, including electrification, the introduction of the internal combustion engine, and the construction of the Interstate Highway System, but since the 1970s the internet boom was the only episode that elevated productivity growth above 2%.
Source: BLS and Fernald (2014)
Slower economic growth has direct consequences for our quality of life. It reduces the chance that today’s generation of young people will double their parents’ standard of living, as has historically occurred across generations. It also increases the burden of public debt by reducing future tax revenues and the size of the economy that finances the debt. The limiting factors mentioned above also have implications for monetary policy. Despite its lackluster growth, the economy may actually be expanding faster than its potential growth rate at present, eventually resulting in upward pressure on wages and the inflation rate and potentially prompting the Fed to raise interest rates sooner rather than later. Finally, slow growth is likely to affect the demand side of the economy in the form of shrinking disposable income and reduced investment.
Demand side proposals to stimulate the economy emphasize the importance of public and private investment. With unfavorable demographic prospects and nominal interest rates close to zero, policy makers also need to fight deflationary expectations. As a response, central banks could raise their inflation targets to 4%, and thereby potentially push real interest rates lower. Supply side policy options for accelerating growth include reforms of the education system, the labour market, and the social welfare system. However, each of these proposals is likely to face political opposition.
Developing countries will feel the effects of reduced demand from rich countries, but many have relatively young populations and rising educational attainment that makes them less vulnerable to the looming growth challenges of the developed world. As a result, future drivers of growth might include India, Latin America, and even Africa. If relatively more global resources flow toward these countries, they may be able to narrow the development gap with the world’s richest countries.
A summary of this forecast is available as a service to the public. For more detailed analysis, subscribe to UHERO's Forecast Project.
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