Failure to launch – US trend growth and monetary policy normalisation
18 August 2016
At each meeting of the Federal Open Market Committee (FOMC), members are each asked to provide their projections of US GDP growth and the appropriate path for the Federal Funds rate over the next three years. Recent history has shown FOMC members to have been serially disappointed regarding the US growth outlook – and this has been reflected in the continued slow process of normalising monetary policy. However, now that the FOMC appears to have accepted that underlying US growth is closer to 2% per year, the appropriate path for the Fed Funds Rate laid out at the June 2016 meeting may be more realistic than prior estimates.
A forecast of US trend growth is published each year by the Congressional Budget Office (CBO). Its most recent projection, shown in Figure 1, implies potential output growth to have permanently slowed following the global financial crisis.
According to the CBO, US potential output grew on average by a healthy 3.5% each year between 1950 and 2007. Of this, 1.6 percentage points was contributed by a growing labour force as the baby boomers, immigrants and increasing female participation swelled the ranks of potential workers. Labour productivity growth made up the remaining 1.9 percentage points.
Between 2008 and 2015, US potential output growth slowed sharply to 1.4% per year. This reflected both demographic factors as the baby boomers began to hit retirement age and slowing labour productivity growth.
Looking ahead over the next 10 years, the CBO forecast US potential output growth to pick up to 2% per year. This is driven by an improvement in labour productivity growth from current lows as capital spending by businesses recovers after the recession. However, the ageing population means that demographic factors will continue to weigh on the contribution of the size of the labour force to potential output growth. This factor alone will knock one percentage point of US trend growth going forward relative to the rate that obtained before 2008.
The FOMC appears to have only gradually accepted that underlying US growth might be persistently weaker. Table 1 records six-month snapshots of the central tendencies of the real GDP forecasts of FOMC members. A clear pattern in most years is for the FOMC to revise down their initial growth forecasts over successive meetings towards a 2% rate. For instance, at the December 2013 meeting the central tendency of FOMC members was for growth in the range of 2.5 - 3.2% in 2016. By the June meeting this year the central tendency forecast had been cut to 1.9 - 2.0%.
As the FOMC becomes less optimistic regarding their outlook for economic growth, it has also on average lowered the path for the appropriate Fed Funds Rate (see Table 2). At the June 2014 meeting, the median view was that the appropriate target rate at the end of 2016 would be 2.5%. At the June meeting this year, the median view had fallen to 0.875%. The long run forecasts of real GDP growth and the appropriate target for the Fed Funds Rate have tended to descend together.
But we may now have reached the bottom of the hill. The central tendency of growth projections at the June 2016 FOMC meeting is now more in line with the CBO’s potential output growth than before. This means that although the FOMC is now less optimistic about the outlook, there is also as a result potentially less scope to be disappointed. Could this mean that the albeit slow path of interest rate normalisation outlined at the June 2016 meeting might now be on a more credible footing?
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