U.S. Economy Near Capacity Slows Growth Potential
December 5, 2018
Since March 2018 there have been more job openings in the U.S. economy than there are people searching for work. The limit on job growth is the availability of potential employees, not job opportunities. The U.S. economy has reached capacity.
Real GDP growth is limited by the growth of the labor supply and the growth of labor productivity. Both have grown slowly since the Great Recession ended. Baby boomer retirement has reduced average labor force growth to 0.5% per year, though it’s been somewhat faster over the past year, at 1.0%. Productivity, measured as real gross domestic product per worker, has grown 0.9% per year since the recession. Productivity also has been edging upward lately, averaging 1.1% in the past year.
At capacity, employment can only grow as fast as the labor force plus productivity. So, we should expect real GDP growth of 1.4% based on rates of growth since the recession, or 2.1% using more recent growth rates.
Real GDP has grown faster than that, 3.0% over the past year. That’s the highest annual growth rate during this expansion. The drop in the unemployment rate from 4.1% in December 2017 to 3.7% in November 2018 made this possible. When unemployment falls, employment grows faster than the labor force.
Consumer demand and the Federal budget deficit are the main reasons for the faster growth. Consumers increased their spending by 3% above inflation. Pay rose (modestly), home values increased and taxes were cut. The Federal budget deficit increased from 3.4% to 4.7% of GDP. The increase is due to the December 2017 tax cut, and rising Social Security and Medicare spending for retired boomers.
Businesses stepped up their hiring to meet the added demand, driving the unemployment rate to a 50-year low. It’s unlikely that the unemployment rate can fall much further and therefore employment growth will be limited by the growth in the labor force.
The labor force grows faster if labor force participation increases, and it has been rising. Participation has increased from 59.6% of the population last December to 60.6% now. This is lower than the 63.4% participation rate at the peak of the last expansion, and lower still than the 64.7% peak at the end of the 1990’s.
Labor force participation has been trending lower. Women’s participation peaked in 2000 at 60.3% of the population. It’s down to 57.2% now. Men’s participation peaked in 1949 (yes, during the Truman administration), at 87.4%, and it’s down to 69.0% now. In each successive expansion, men’s participation has never regained the previous expansion’s high, in almost 70 years and 11 expansions. It would be news if it happened in this expansion. Labor force participation may edge upward with improving job opportunities, higher wages and lower income taxes, but this is unlikely to be an important source of growth.
Productivity has grown more slowly in the last ten years than at any time in the past century. Explanations are many. Perhaps we’ve reached the physical limits of many technologies. Perhaps the domination of high tech industries by a few big firms is inhibiting the spread of innovation. Perhaps it’s an overhang from the financial crisis of the Great Recession, with both lenders and borrowers still reluctant to make loans and investments in risky projects. Perhaps slower population growth means that businesses see less need for innovations to expand capacity.
The December 2017 tax cut was intended in part to address this problem. The cut in corporate income taxes should increase returns on investment. Added investment would add to the capital stock, which would raise productivity. Investment as a share of GDP has lagged in this expansion. It peaked at 20.3% in the 1990’s, and at 19.9% in the 2000’s, but it’s been up and down between 17% and 18% since the end of 2013. The rate has moved up a little since December, from 17.4% to 18.0%, so perhaps the tax cut is having some effect. The growth rate of capital goods orders has dropped since January, though, so an investment boom seems unlikely in the near future.
Federal Reserve policy is working at cross-purposes to the tax cut. The economy is already pressing against capacity limits, which risks higher inflation. Additional spending on investment increases this risk. The Fed has responded by raising interest rates, but this may partially offset the higher return on investment. The tax cut is expansionary. Federal Reserve policy is contractionary.
The Fed has increased the federal funds rate eight times since the end of 2015, with another quarter-point increase expected in mid-December. The rate is 2.2% now. The Fed is likely to take a “wait and see” attitude in 2019, judging whether to increase the federal funds rate three or four times based the direction of economic indicators. Lower unemployment and higher inflation would make for more increases. If unemployment and inflation are stable, and financial markets are not, we’ll see fewer rate hikes. The Fed regards a federal funds rate between 3% and 3.5% as neutral—neither expansionary nor contractionary. We’ll hit that range with three quarter-point increases in 2019.
The Fed’s target inflation rate is 2%, and inflation is near that target. The all-items consumer price index has increased 2.2% over the past year, the same as the “core” CPI, which excludes energy and food. Inflation is not a problem yet, which gives the Fed room to pause rate hikes if needed.
An economy straining at capacity should see rising inflation, but this depends in part on rising wages. Wages have increased by about one percent per year above inflation since the beginning of 2016. This is much slower than the 1.5% to 2.5% increases in the past two expansions. Perhaps slow productivity growth makes businesses reluctant to raise wages, even in the face of labor shortages.
An economy at capacity, contractionary monetary policy, a bigger Federal budget deficit and somewhat higher inflation explain rising interest rates. The yield on three month Treasury bills moves in lock-step with the federal funds rate, so it has risen from 1.3% last December to 2.3% in November. The 10-year Treasury bond yield has increased from 2.4% last December to 3.1% in November. Both interest rates are likely to trend upward in 2019.
Note that the shorter-term Treasury yield has risen more than the longer-term yield. The difference is narrowing. Recently financial markets were alarmed to see the yield on the 5-year Treasury bond drop slightly below the yield on the 3-year bond. Such yield curve inversions have been leading indicators of recessions in the past. The interest rate on the 3-month Treasury bill rose above the rate on the 10-year bond in advance of the last two recessions.
Our expansion is 114 months old this December. If it lasts through July 2019 it will be the longest expansion in U.S. history, surpassing the 10-year expansion during the 1990’s. Expansions die of shocks, not old age, but shocks are by definition shocking—hard to predict. Possible shocks include a heightened trade war, weaker growth in China, a government shutdown or other political turmoil in the U.S., too-rapid interest rate increases from the Fed, a disorderly Brexit, or the bursting of some as yet undetected financial market bubble. It probably would take more than one shock to cause a recession. Leave an oil price hike off this list. Now that the U.S. is a major oil producer again, higher oil prices might help as much as hurt.
What to expect in 2019?
If the labor force grows as it did in 2018, and productivity continues its slow upward trend, we could see real GDP grow 2.3%. The unemployment rate is unlikely to fall much further, especially as the effects of the tax cut wear off. Leave unemployment at 3.7% by the end of 2019. Inflation should increase, but with wages growing slowly and the Fed ever vigilant, core inflation should tick upward to 2.3%, with the all-items rate a little higher if OPEC and Russia cut oil production and oil prices rise. Interest rates are going up. The Fed likely will raise the federal funds rate above 3.0% by the end of 2019, with three, not four, quarter-point increases. The 3-month Treasury interest rate will rise by the same amount. The 10-year Treasury interest rate will rise less than that, but the guess here is it will not invert. Put the 3-month Treasury interest rate at 3.3% and the 10-year rate at 3.8% by this time next year. Slower growth, but no recession, so by mid-summer our expansion should become the longest in U.S. history.