Tag: potential output

Five Revisions of Its Model That the Fed Should Make or Test

Posted on by Brad DeLong

Must-Read: Five Revisions of Its Model That the Fed Should Make or Test: And I do not think that the Fed is handling the process of revising its thinking properly.

I say that the Fed should, right now, be rethinking its estimates of:

  1. the long-run real natural rate of interest,
  2. the natural rate of unemployment,
  3. the slope of the Phillips Curve, and
  4. the gearing between recent past deviations of inflation from its target and expectations of future inflation.

Ryan Avent says that the Fed is rethinking (1) and (2), but also rethinking a (5): its estimate of long-run potential output growth. I don’t think there is evidence to rethink (5). I think that the consilience of a low pressure economy and apparent sluggish potential output growth is just too large for people to be satisfied rejecting it as a mere coincidence. Ryan agrees with me, and asks why the Federal Reserve seems to want to jump to conclusions about (5) rather than testing it. I agree. But I also want to ask: why isn’t the Fed rethinking its views on (3) and (4) as well? There is powerful evidence that they are different from the implicit model Fed policy has been running off of for the past decade as well:

Ryan Avent: Absence of Evidence: The Fed Rethinking One Thing too Many:

OFFICIALS at the Federal Reserve, a few of them anyway, seem to be rethinking their views of the economy in some dramatic ways….

Ben Bernanke suggests… top policy-makers still have confidence in their mental model of the economy; they have just been tweaking a few of the parameters… long-run… GDP growth… unemployment… and their benchmark interest rate…. The latter two [what I call (1) and (2)]—a lower unemployment rate and a lower long-run interest rate—clearly imply that rates will rise more slowly to a lower overall level. The projection of a lower potential growth rate [what I call (5)], however… suggests, for instance, that the American economy is running closer to its “speed limit”… push[ing]… toward a more hawkish stance…. These three revisions are not created equal…. [(1) and (2)] are clearly justified…. [(5)] is different, however. Available evidence is consistent with a world in which long-run potential growth has fallen… but… also… with an economy… growing slowly because of too little demand… in which both strong employment growth and low productivity growth are side effects of the low level of wages.

The only way to resolve the question in a satisfying way is to test it: to push the economy beyond the estimated potential growth rate and see if inflation rises…. Bernanke argues that Fed officials are willing to be a little patient with the economy, to see whether running it a little hot brings more workers into the labour force and encourages productivity-enhancing investments. It certainly seems clear to me that overshooting is the right way for the Fed to err….

But I am less confident than Mr Bernanke in the Fed’s openness to overshooting. It did not exactly intend to run the unemployment rate experiment that demonstrated how run its previous projections had been…. Now, the Fed looks all too willing to revise down its GDP growth projections without ever really testing them…. There is far too little radicalism at the Fed. It risks making permanent a low-growth state of affairs which is largely a consequence of its own excessive caution.

I would say may be rather than is. But one thing we agree on is that it is definitely the Fed’s responsibility to find out. And on its current policy trajectory it will find out only by accident–only if the economy turns out to be stronger than the Fed currently projects.

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Must-read: Dean Baker: “Prime-Age Workers Re-Enter Labor Market”

Posted on by Brad DeLong

Must-Read: The Federal Reserve is looking at the past six months and seeing significant improvement in the labor market. It is also looking at financial markets and seeing increased pessimism about inflation. It is having a difficult time reconciling these two.

The reconciliation is, I think, that financial markets now believe that the Phillips Curve is flatter and that the NAIRU is lower than they thought two years ago–and they are likely to be right:

Dean Baker: Prime-Age Workers Re-Enter Labor Market: “The economy added 215,000 jobs in March…

Graph Employment Rate Aged 25 54 All Persons for the United States© FRED St Louis Fed

…with the unemployment rate rounding up to 5.0 percent from February’s 4.9 percent. However, the modest increase in unemployment was largely good news, since it was the result of another 396,000 people entering the labor force. There has been large increase in the labor force over the last six months, especially among prime-age workers. Since September, the labor force participation rate for prime-age workers has increased by 0.6 percentage points. This seems to support the view that the people who left the labor market during the downturn will come back if they see jobs available. However even with this rise, the employment-to-population ratio for prime-age workers is still down by more than two full percentage points from its pre-recession peak.

Another positive item in the household survey was a large jump in the percentage of unemployment due to voluntary quits. This sign of confidence in the labor market rose to 10.5 percent, the highest level in the recovery, although it’s still more than a percentage point below the pre-recession peaks and almost four percentage points below the levels reached in 2000.

While the rate of employment growth in the establishment survey was in line with expectations, average weekly hours remained at 34.4, down from 34.6 in January. As a result, the index of aggregate hours worked is down by 0.2 percent from the January level. This could be a sign of slower job growth in future months.

Must-read: Charles Steindel (2009): “Implications of the Financial Crisis for Potential Growth: Past, Present, and Future”

Posted on by Brad DeLong

Must-Read: Charles Steindel (2009): Implications of the Financial Crisis for Potential Growth: Past, Present, and Future: “The scale of the recent collapse in asset values and the magnitude of the recession…

…suggest that activities connected to the increase in values over the 2002-07 period—notably, expansion of the financial markets, homebuilding, and real estate—were overstated. If this is true, aggregate U.S. economic growth would have been overstated, implying that previous rates of potential gross domestic product (GDP) growth may also have been overstated and that the trajectory of potential GDP may be slower going forward. Slowing growth in the finance, homebuilding, and real estate sectors could hold back aggregate growth. A detailed examination of these sectors’ direct contributions to GDP, however, suggests that overstatements of past growth would likely not have made a large difference in recorded GDP growth. Slower growth in these sectors would have, at most, a moderate direct effect on aggregate economic activity. The recent experience’s longer term effects on GDP would seem to stem largely from factors other than the retrenchment in these sectors.

What is the economy’s speed limit?

Posted on by Brad DeLong

More on the very-sharp Ryan Cooper’s gotten one mostly wrong…

The two questions are (a) how much higher could expansionary fiscal and cooperative monetary policy permanently push annual GDP up above its current trend without triggering massive inflation, and (b) how large would the expansionary policies have to be to push the economy up that far? My guesses are 5% to (a)–that we could permanently raise annual GDP $800 billion relative to our current trajectory without triggering an upward spiral in inflation–and that we would need $300 billion more of annual government purchases. to get us there to (b).

Ryan Cooper:

Ryan Cooper: Who’s Afraid of John Maynard Keynes?: “Does the economy have room to grow?…

…Could we create many more jobs and wealth if we really tried, or have we reached the limits of what we can produce? This… is at the heart of a recent dispute among academic economists… nominally centered on Bernie Sanders’ economic plan, but also illustrates a major fault line in the practice of theoretical economics today…. [Gerald] Friedman… assumed a model in which Sanders’ huge stimulus would push the economy up to full capacity (meaning full employment and maximum output), after which it would stay permanently at a higher level…. However, the key assumption behind the mainstream model is that an economy always tends towards full employment…. [But] even by conservative assumptions we are still something like $500 billion under total economic capacity, productivity has been consistently very weak, and there is absolutely nothing on the horizon that looks like it will return us to the level of employment we had in 2007, let alone 1999…. What’s more, a Friedman-style model in which a stimulus delivered to a depressed economy returns it to full capacity, after which it stays there, is not ridiculous…

Let’s start with one of my favorite workhorse graphs:

Playfair equitable graphs

Starting in 2006 residential construction fell to the very bottom of the chart, and it has stayed there: more than 1.5%-points of GDP below its 2007-peak share of potential GDP. Starting in 2008 business investment fell to the very bottom of the chart, and then took a long tine to recover from its nadir of 2.5%-points below its 2007-peak share of potential GDP. Between 2007 and, say, the end of this year the cumulative shortfall has been some 18%-point years of residential construction not undertaken, and some 8%-point years of business investment not undertaken.

In a world with a capital-output ratio of 3 and a capital share of income of 30%, that shortfall would generate (under somewhat heroic analytical assumptions) a reduction of some 2.6%-points of GDP in the cumulative growth of potential output relative to what it would otherwise have been. That is the damage done to growth in America’s long-run economic potential from the investment shortfall since 2007. And then there is the equal or larger reduction in the growth in America’s long-run economic potential from the labor shortfall–workers not trained, workers not gaining experience, the breaking of ties to people who might hire you or might know of people who might higher you. Add up those two, and I get a 6%-point reduction in what our productive potential is relative to the pre-2008 trend. Thus 6%-points of the current gap between production now and the pre-2008 trend has been lost to the years that the locust hath eaten. And 5%-points remains as a gap that could quickly be closed by expansionary fiscal policy.

And we should close that gap. But a mere $140 billion or so of increased government spending is very unlikely to get us there. That would require a multiplier of nearly six–that only 17.5% of dollars earned as income from higher government spending leak out of the flow of spending on domestically-produced commodities either as savings or as spending on imports. And we know that it’s more like 33%-40% of dollars that so leak. That gives us a multiplier of 2.5-3. And that gives me my desire to see $300 billion more of government purchases.

What if we don’t get that extra spending? Well, perhaps we will get a residential construction boom to return us to economic potential. But don’t bet on it. Perhaps we will get an export boom to return us to economic potential. But don’t bet on it. Perhaps businesses will become wildly more optimistic about the future and a business investment boom will return us to economic potential. But don’t bet on it. Perhaps consumers will decide–after just living through 2007-2016–that they have not borrowed enough, and go on a spending spree to run their debts up further. But don’t bet on it.

No, if we don’t take active steps to boost spending, what will happen is not that economic growth will accelerate to return us to an economic potential that is itself growing at 2+%/year. What will happen is that low investment and underemployment will continue to do damage to the growth of potential and our economic potential will grow at 2-%/year until actual output is once again at potential output. But that will not be because actual has sped up its growth to catch up to potential. It will be because potential has slowed down to fall back to actual.

And the claim that in the long run (in which we are all dead) the economy’s actual level of output converges to potential? Four things can cause this to happen:

  1. Potential can slow.
  2. Something–a spending boom by somebody–can boost actual.
  3. Deflation can lead to lower interest rates as deflation carries with it a decline in the intensity of demand for a stable nominal stock of money. But in the modern world we certainly do not have inflation. We double-certainly do not have central banks that keep the nominal stock of money stable. And we triple-certainly have no room for interest rates to fall further
  4. The gap between potential and actual production can lead the central bank to lower interest rates. That cannot happen. It could lead the central bank to resort to additional extraordinary stimulative measures. But that is not going to happen either.

You may ask: Why can’t we recover more than 5%-points of the 11%-point gap between current production and what we thought back in 2007 was our trend growth destiny? If a low-pressure economy can reduce potential, why won’t a high-pressure economy increase potential? The key is easily recover. Easily. When a lack of markets or a lack of financing keeps investments that had obvious payoffs from being made, the costs are large. When a boom encourages investments to be made that look profitable only as long as the boom and the exuberance that accompanies it lasts, the long-run benefits are smaller. We as a country did benefit from MCI-WorldCom’s investments in the fiber-optic backbone in 1998-2000. But we did not benefit by nearly as much as MCI-WorldCom was calculating in its irrational exuberance bordering on fraud.

I would love to be wrong. I would love to discover that a high-pressure economy with spending more than halfway back to the pre-2008 trend would be consistent with relatively-stable inflation and with rapid-enough growth of economic potential to quickly catch us back up to that trend. But I don’t expect that that would be the case.