Is a slowdown in economic growth a necessary condition for a further decline in inflation? This concerns whether interest rate cuts will be postponed. Powell's two remarks this month sent the exact opposite signal...
Over the weekend, Nick Timiraos, a well-known journalist who is regarded as the “mouthpiece of the Federal Reserve” and known as the “New Federal Reserve News Agency,” wrote an article pointing out that Fed Chairman Powell hinted at an important shift this month. He said that there is no need to worry that strong economic growth will lead to price increases, but he then quickly adjusted this view, causing the situation to reverse at any time.
Powell believes that the strength of the economy may not be cause for concern is that the potential growth rate of the US economy seems to have temporarily increased because supply chain bottlenecks have been alleviated, the number of employed people has increased, and productivity (output per worker) may also increase.
This highlights why Powell downplayed concerns that a sharp rise in the US economic growth rate to 4.9% over the summer would increase price pressure. While growth may have slowed this quarter, the forecast is still quite healthy, while inflation and wage growth continue to slow.
In the main model used by most economists (including the Federal Reserve), when economic growth continues to exceed the long-term trend level of around 2%, the unemployment rate falls and inflationary pressure increases. The reverse is also true.
Until this month, Powell insisted that a period of “below-trend growth” was needed to reduce inflation. However, the economic growth rate has exceeded 2% this year, and the unemployment rate has risen, yet the core inflation rate has declined to 2.8% in the six months up to September, down from 4.5% in the previous six months. At a press conference on November 1, Powell changed his remarks, saying that the current economic growth needs to be “below potential levels.”
Powell made a delicate but important distinction between the economy's long-term trend growth rate and short-term potential growth rate. The potential growth rate may be above or below the long-term trend level, depending on labor supply and productivity.
All in all, Powell's view remains that, in the long run, the US economic growth rate should be 2%. However, he said that as immigration increases and labor force participation rates rise, and supply chain bottlenecks ease, short-term speed limits on economic growth have increased.
Depressed supply achieves catch-up growth
Powell said that the potential growth rate “is currently one or two years above the trend level”. “This means that although this year's growth rate may have reached 2%, it is still lower than the growth rate of potential economic output.”
Powell's remarks provided an explanation for Fed officers' long-held soft landing expectations, that is, inflation may fall without a sharp rise in the unemployment rate during the last fight against inflation in the early 80s of the last century. In fact, the pandemic may have caused a one-time decline in the supply capacity of goods and services markets, and they are now catching up.
This year, the supply-side rebound of the US economy finally became apparent. Supply chain bottlenecks have been alleviated, immigration and increased labor participation have boosted the job market, and the boom in newly built apartments during the pandemic hit the market. These factors have helped depress commodity prices, rents, and wages.
San Francisco Federal Reserve Chairman Daly said that the entry of more workers into the labor market is a safety valve that can “slow down wage growth, but demand will not be drastically adjusted.” She said the prospects for lowering inflation without a serious recession are bright because “other sectors of the economy that we have no control over have been adjusting.”
For economists who have long been unconvinced of the orthodox theory that a large increase in unemployment is needed to reduce inflation, this is “a huge relief.”
That doesn't mean the Fed's interest rate hike is wrong, though. Goldman Sachs chief US economist David Mericle (David Mericle) said that at a time when the supply side of the economy is recovering, interest rate hikes have played an important role in curbing demand. “Supply will always catch up,” he said. “But it's important to ensure that supply and demand return to a better balance in a timely manner.”
Will the increase in supply and productivity continue?
Supply-side improvements may also benefit from productivity growth in the second and third quarters.
The question is whether this higher potential growth will continue. If this is true, this will strengthen the Fed's confidence that inflation will return to the 2% target, and may begin lowering interest rates early from a 22-year high of around 5.3%.
Julia Coronado (Julia Coronado), founder of economic consulting firm MacroPolicy Perspectives, is optimistic that supply-side improvements will continue due to increased business investment and a hot labor market that increases the efficiency of matching employees with new jobs. “This would put the Fed in a better position. “It doesn't need to continue to hit the economy until it falls into recession,” she said.
However, Powell later warned that the recent rise in potential growth rates may be over. For example, the growth rate of immigration may slow or decline in the future, while higher childcare costs may cause some working mothers to withdraw from the labor market.
Without help from the supply side, the Fed will return to its default assumption that a slowdown in economic growth is a necessary condition for a further decline in inflation, thereby delaying interest rate cuts.