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The U.S. economy is stronger than you think

The U.S. economy is stronger than the GDP growth rate suggests, and now is the time for the Federal Reserve to begin gradually raising the federal funds target rate. That was the key message regarding the national financial markets delivered at the 52nd Annual ASU/JPMorgan Chase Economic Forecast Luncheon.

2017-11-29

Jim Glassman's slides

The United States economy is stronger than the GDP growth rate suggests, and now is the time for the Federal Reserve to begin gradually raising the federal funds target rate. That was the key message in both the national financial markets forecast and the national economic forecast delivered at the 52nd Annual ASU/JPMorgan Chase Economic Forecast Luncheon.

Jim Glassman, who is managing director and senior economist at JPMorgan Chase, shared his outlook for financial markets in 2016. Charles Plosser, former president of the Federal Reserve Bank of Philadelphia, presented his take on the prospects for the U.S. economy. Both focused on the health of the economy as a backdrop for the Fed’s likely policy moves.

The Federal Reserve doesn’t control interest rates broadly, but rather the federal funds rate, which is the interest rate banks charge each other for overnight loans; the Fed sets a target rate for trading in the federal funds market. The Fed funds rate then affects the interest rates that banks charge consumers; market interest rates are higher but have followed the same trend as the Fed funds rate.

Raising or lowering the Fed funds target rate is one tool the Fed has to accomplish its aim of balancing unemployment and inflation. When the economy is weak, unemployment is high, and inflation is not a risk, the Fed can lower its target rate to boost job growth. But when the economy is strong and unemployment is low then inflation becomes a risk and the Fed has to raise its target rate to prevent the economy from overheating.

How does the Fed know when it’s time to take its foot off the gas or apply the brakes? It’s not an exact science. The Fed’s official target is a 2 percent inflation rate. Above that, time to slow down. Below, okay to speed up.

GDP growth is weak, relatively

Is the economy healthy enough that the Fed should begin rolling back its unprecedented accommodative monetary policy? Glassman and Plosser both said, unequivocally, yes.

According to Plosser, “the fundamentals of the U.S. economy are sound.” He anticipates the economy, as measured by gross domestic product, will continue to expand by about 2.5 percent a year.

Yet 2.5 percent GDP growth per year is by historical standards quite anemic. (Between 1929 and 2007, the average annual rate of real GDP growth was 3.4 percent.) That’s why many Americans are surprised to hear the Fed talk of raising interest rates. As the thinking goes, “Why would the Fed raise rates if the economy is still weak?”

Glassman explained, “Pessimism about the state of the U.S. economy appears exaggerated, perhaps reflecting the widespread view that the economy’s unusually slow real GDP growth rate is a reflection of a fragile and vulnerable economy.”

In reality, the economy is doing quite well — strength that is reflected in other, perhaps even more important measures than GDP. “In fact,” said Glassman, “the U.S. economic recovery has been quite normal in most respects. The economy’s foundation is far stronger than many assume.”

Set against the backdrop of a truly recovering economy, it makes sense that the Fed has signaled its plans to begin raising the Fed funds target rate soon. Plosser explained, “We should no longer have the kind of monetary policy that we would have if we were in a recession.”

The ‘measures that matter’ are strong

"All of the economic performance measures that really matter in people’s lives are normal,” Glassman explained. For one, job growth has been strong. “The economy has added more than 200,000 jobs a month on average this year.”

For both Plosser and Glassman, the health of the U.S. labor market is the most important sign of overall economic health, and a leading reason for the Fed to begin raising the fed funds target rate. “The Fed looks to the job market for clues about how the economy is really performing,” Glassman explained, “because a ‘good’ GDP rate is whatever gets unemployment down.”

And unemployment is down. The unemployment rate is down to 5.0 percent. The underemployment rate, which includes people who are working part time but want to work full time as well as people who got discouraged and stopped looking for work, is 9.8 percent, down from nearly 14 percent two years ago.

As another sign of economic health, Plosser cited strong consumer spending, which accounts for almost 70 percent of GDP in the U.S. “Consumer spending has contributed to solid growth for the last two years, growing above 3 percent in every quarter except two of the last eight. The strong consumer is one good reason why I, and other economists, see the fundamentals in place for continued economic expansion.”

The health of the U.S. economy is reflected in the stock market, Glassman said. “The stock market was prompt in anticipating a normal economic recovery, as it usually is, with valuations back to normal relative to current earnings.” Moving forward, he said, “The market momentum may now shift onto a slower trajectory as the focus shifts to the longer-term fundamentals, which remain promising.”

‘Slower trajectory’ does not mean decline, Glassman explained. “From an economic perspective there’s no reason to think the market will decline, but it’s not reasonable to think that it will continue to rise at the same pace. For the last seven years, stock market gains have been all about recovery, but as the economy gets closer to ‘full’ employment, ongoing stock market gains will be driven more by perceptions about the economy’s longer-term prospects than cyclical recovery themes.”

Inflation will rise

Since the primary measure of inflation (consumer price index, or CPI) remains close to zero, and the Fed targets an inflation rate of 2 percent, some people are puzzled by the Fed’s signals that it will begin to raise the Fed funds target rate.

But Plosser explained that the CPI has been pushed down by the significant decline in oil prices — not a permanent phenomenon. In contrast to CPI, inflation as measured by the “core” CPI, which excludes food and energy, is 1.9 percent.

“Barring some dramatic event that sends oil prices or some other good or service plummeting in the coming months, it seems most likely that inflation will gradually move toward 2 percent,” Plosser said.

It’s time for the Fed to move

Both Plosser and Glassman said it’s time for the Fed to begin raising the fed funds target rate. “With the federal funds rate near zero, this suggests that the real, or inflation adjusted short-term policy rate is less than minus 1 percent,” Plosser said. “Such a low real policy rate seems inappropriate for a growing economy that is at, or near, full employment and price stability.”

Glassman said that the Fed would eventually raise its federal funds target rate from its current rate of between 0 and 0.25 percent to somewhere in the 3 to 4 percent range. As long as inflation remains subdued, he expects the Fed to do so very gradually. “That means short-term interest rates will remain accommodative for the next two to three years.”

So when the Fed begins to raise the Fed funds target rate, it is “unlikely to be disruptive for the financial markets,” Glassman said. That is in part because the Fed intends to get to its long-run target of 3–4 percent gradually and in part because the markets expect the move. “The market believes that as long as inflation remains near the 2 percent target the Fed will be cautious and go slow.”

“Remember that the Fed is taking its foot off the gas, not hitting the brakes,” Glassman explained. “The idea that the Fed will raise the Fed funds target rate slowly is already discounted in interest rates,” he said.

“Equity investors may turn cautious in the early days of Fed tightening, but monetary actions that remove unnecessary stimulus are not a threat to economic recovery nor are they likely to be a long-lasting challenge for the stock market,” Glassman said. “Soon after the Fed begins its gradual normalization campaign, equity investors likely will turn back to the earnings fundamentals that have lifted stock prices to current levels.”

There are risks of not moving soon enough

Glassman and Plosser both said that there are risks if the Fed waits too long to take its foot off the gas. Plosser explained three such risks: “First, if monetary policy is doing what the Fed says it does, then low rates are distorting market prices and forcing investors to engage in more risk taking. Second, waiting to initiate normalization puts at risk the Fed’s desire to approach normalization at a gradual pace. Third, by waiting, the Fed is risking a large inflation down the road if normalization doesn’t go smoothly.”

Bottom line from both Plosser and Glassman: The labor market is strong. Inflation is on its way to 2 percent. It’s time for the Fed to begin gradually raising the fed funds target rate — and that’s a good thing.

— Promotion and live radio support for the 52nd Annual ASU/JPMorgan Chase Economic Forecast Luncheon was provided by KFNN Money Radio.

Economics