Policymakers face a critical decision on interest ratesby David Hale / November 10, 2014 / Leave a comment
The US economy is showing signs that its growth rate is accelerating from a little over 2 per cent during the past five years to 3-3.5 per cent. There have been large employment gains during the past few months. There was a large increase in new home sales during August. The state and local government sector is boosting output after a long period of contraction. The US economy has several growth locomotives. The business capital stock is now the oldest since 1958. If firms are to bolster productivity, they will have to increase investment.
The average age of a US motor vehicle has increased from 8.5 years two decades ago to 11.4 years today. As new cars are far more fuel efficient than older models, consumers have a strong incentive to buy a new vehicle. Housing starts are just below one million per year. As a result of new household formation and houses being demolished, the US needs about 1.6m new homes per year. The number of housing starts should rise to 1.2m next year and 1.6m by 2017.
The US is also in the midst of an oil and gas boom. Oil output has risen from 5.5m barrels per day (mb/d) five years ago to a present level of over 8.5mb/d. It could rise to 10 mb/d in the next three years. The oil and gas boom has created a great demand for capital goods.
Janet Yellen, Chairman of the US Federal Reserve, stresses that future monetary policy will be very data dependent. If the data suggests a good recovery, the Fed could decide to raise interest rates as early as next March. If the recovery is more subdued, she could wait until June or later. There are four district presidents in Philadelphia, Kansas City, Richmond and Dallas who would like to raise interest rates in the near future, but they cannot command majority support. Two of the hawks in Philadelphia and Dallas will also retire next March and April.
The disagreements at the Fed centre on how to interpret recent employment data. The unemployment rate has fallen to 5.9 per cent. The doves at the Fed believe there is still a great deal of slack in the labour market. They point to the fact that wage growth was flat in September and has risen only 2 per cent year on year. Fed governors will want to see signs of wage acceleration before they raise interest rates.
In September, the Republicans approved resolutions to fund the government through December because they did not want to create a crisis right before the mid-term elections.
Senate Republicans have an ambitious agenda. They want to approve the Keystone XL Pipeline. They want to approve new free trade agreements in the Pacific and with Europe. They want to speed up federal approvals for new natural gas projects. They want to repeal the tax on medical devices which was enacted to help fund Obamacare. They want to reform the corporate tax system by lowering tax rates and switching to a territorial tax system for multinational companies—most OECD countries use the territorial tax system.
The US has made progress in reducing its fiscal deficit. In the fiscal year just ended, the deficit fell to $483bn, or 2.8 per cent of Gross Domestic Product, compared to 9.8 per cent back in 2009. The deficit has declined because of both improvements in tax receipts and the imposition of a sequester—automatic spending cuts. Now that the US is returning to an air war in the Middle East, Congress may have to stop the declines scheduled to occur in military spending.
One of the Fed’s challenges next year will be determining the country’s potential growth rate. Once the economy achieves full employment and has little slack in the labour market, the Fed will have to decide how to set monetary policy. The long-term growth rate of the US economy has been above 3 per cent, but many economists believe it may now be less than 2 per cent. Productivity growth during the past two years has been only 0.9 per cent compared to 2.7 per cent during 1950-1973. The growth rate of the labour force has also slowed to only about 0.6 per cent per annum from over 2 per cent 25 years ago.
This data suggests the US may have a potential growth rate of only 1.5-2 per cent after 2016. If the Fed accepts that potential growth is less than 2 per cent, it could be forced to raise interest rates back into the 3-4 per cent range by 2017. The Fed’s own survey of the members of the Federal Open Market Committee, the body that sets interest rates, suggests they expect rates to rise back to 3.75 per cent by 2017. The one factor which could delay rate hikes is the weakness of the global economy, especially Europe, and the strength of the dollar. Economic models suggest that a 10 per cent appreciation of the dollar can reduce output growth by 1 per cent within 12 to 18 months, by depressing exports and boosting imports. The dollar has been strong as investors discount the possibility of the Fed raising interest rates while the European Central Bank and the Bank of Japan pursue a more aggressive easing policy.
The US economy has grown by 11.5 per cent during the past five years compared to 22.4 per cent during the first five years of previous recoveries in the last six decades. This business cycle is now 63 months old compared to an average life of 72 months for earlier recoveries. There is no reason for this business cycle to end during the next two or three years. Inflation is still only 1.5 per cent and could decline during the fourth quarter because of falling petrol prices. Many Fed governors do not want to tighten policy until inflation exceeds 2 per cent.
Either the Federal Reserve or the Bank of England will be the first central bank to raise interest rates during the first half of next year. Both countries now have growth rates exceeding 3 per cent while unemployment has fallen sharply. As the recent volatility of financial markets will testify, investors are trying to determine when the Federal Reserve will finally act. The Fed’s communiques are saying it will not raise interest rates for a considerable time. This is a confirmation that many senior Fed officials are afraid that hiking rates prematurely could jeopardise the recovery. As a result of the legacy of the financial crisis, they don’t want to repeat the mistakes the Fed made in 1937 by tightening policy after the economy escaped from the 1929-1933 depression.
The US will finally have lift-off next year, but by 2017 the big issue will be the economy’s potential growth rate. It is declining and will impose constraints on growth once the economy achieves full employment.