You ask me, the important DC event of the moment wasn’t last night’s State of the Union address. It’s the far less scrutinized meeting going on at the other end of town, over at the Federal Reserve.
Later this afternoon, the Fed’s interest-rate-setting committee will release their monetary policy statement. They are widely expected to pause this month in their “normalization” campaign, i.e., not further raise the interest rate they control. But their statement will likely reinforce their view that the economy is at full employment, its resources are fully utilized, and their policy thrust will continue to shift from achieving full employment to maintaining price stability. Simply put, more rate hikes are forthcoming.
Their view is not broadly supported by the inflation data, as I’ll show in a moment, but according to an important new paper released this morning by CBPP’s Full Employment Project (FEP), the Fed’s perspective, along with that of other influential economic institutions, like the CBO, has a more fundamental problem: potential GDP is higher than they think it is.
Potential GDP is the level of economic output produced by an economy at full utilization. If you think of the economy as a water glass, full employment implies the glass is filled to the brim. Now, if you’re the Fed, to avoid a spill (inflation), you must stop pouring when you think you’re at the brim. But what if the glass is bigger than you thought? Then the risk is that you’ll stop pouring too soon, at great cost to those who haven’t yet had a drink!
Our new FEP paper, by Olivier Coibion, Yuriy Gorodnichenko, and Mauricio Ulate (CGU) makes precisely that latter case:
“CBO’s and other similar estimates of potential output are too pessimistic, and as such, they encourage policymakers, such as those at the Federal Reserve, to accept lower levels of potential than those which could be achieved. This pessimistic view and associated policies could be extremely costly to U.S. households…Most recently, this has led to some frequently used estimates of potential GDP that are as much as $1.2 trillion, or nearly $10,000 per household, below our preferred estimate.”
What do CGU know that the potential-GDP low-ballers don’t? They borrow a statistical method from a paper by Blanchard and Quah that they claim does a better job separating out temporary and permanent shocks to the economy, thereby getting a more accurate bead on the size of the water glass.
Here’s why that’s so important. Suppose the economy gets whacked by a negative shock like the bursting of a credit bubble. Demand falls sharply and a bunch of people temporarily leave the labor market. A bunch of firms cut back on their investment. Recession ensues. That’s a classic, temporary demand shock. The fundamental supply factors that drive long-term economic growth—labor supply, innovation, the amount of capital per worker—haven’t been permanently thrown of course. Once balance sheets recover and credit flows resume, the economy should make up its losses and revert back to its previous growth rate.
Contrast that with a permanent supply shock, like the one with which we and some other advanced economies are currently dealing: an aging population. Absent a big increase in immigration flows (now we’re back to Trump’s speech), that lastingly slows the long-term growth of the labor force and thus lowers potential GDP.
The problem that CGU document is that current statistical methods employed by the Fed, CBO, and others conflate these two types of shocks, often mistaking temporary downgrades for permanent ones. That, in turn, leads policy makers, like those meeting across town as we speak, to underestimate the size of potential GDP. There’s more room in the glass than they think.
To be clear and fair to all, no one, including CGU, knows the actual size of the glass, which is growing and shrinking all the time in ways that are beyond our capacity to accurately measure, especially in real time. So, while their method is an improvement over the dominant ones in use today, we must be humble about our ability to accurately measure potential.
This is one of the points emphasized by Olivier Blanchard (recall that he was one of the progenitors of the method used by CGU) who was kind enough to provide the FEP with a short comment on CGUs paper. Blanchard writes:
“The basic point of the note by Coibion et al is an extremely important one. Current methods of estimation of potential output do not distinguish between different sources of shocks behind output fluctuations…[CGU’s analysis] is clearly an improvement upon existing methods…But there are limits to it. Some of these limits can be addressed, by looking at more variables, and so on. Some not so easily. In short, it is a better tool, but it is not a magic one. It must be added to, not replace, the existing panoply.
To me, the best tool remains the inflation signal, at least as far as the labor market, and unemployment, goes. Inflation is the canary in the mine, and a very reliable canary. If the labor market is too tight, if unemployment is below the natural rate, workers will ask for higher wages, firms will be willing to offer higher wages either to keep them or recruit new ones, firms will start increasing prices in order to cover higher marginal cost, etc.”
Which brings us full circle back to the Fed’s meeting. The last reading of their preferred inflation gauge—the core PCE—was up 1.5 percent in 2017, another in a multi-year series of downside misses re their 2 percent target. Some gauges of inflation expectations are tilting up some, and market interest rates have nudged up a bit too, but none of the indicators are signaling serious price pressures. I agree with Blanchard re the limits of CGUs or anyone else’s statistical estimates of potential GDP. But the fact is that the inflation record is strongly consistent with their findings.
We must, therefore, consider the possibility that the glass is bigger than we thought it was, that current methods conflate temporary with permanent shocks, and that there’s more space between actual and potential GDP than the Fed thinks. Closing that gap could make a world of difference to those who are still thirsting for the benefits of the current expansion to come their way.