Once again, the Fed was wrong
By Scott Sumner
About 2 years ago, I predicted that 3% NGDP growth was the new normal. At the time, the Fed predicted significantly higher trend growth (both RGDP and NGDP.)
The Fed has a big NGDP problem. It’s becoming increasingly clear that when the labor market recovers, RGDP growth will be very slow, maybe 1.2%. Add in about 1.8% on the GDP deflator, and 3% NGDP growth looks like the new normal, assuming the Fed intends to stick with 2% PCE inflation targeting. Bill Woolsey wins!!
With today’s figures, it is now pretty clear that I was right and the Fed was wrong.
(This has been repeatedly true of one issue after another, over the past 8 years. For instance, in December I predicted the Fed would raise interest rates in 2016 fewer than the 4 times they were predicting.)
To estimate the rate of trend growth in real GDP, you need to go back to a period where the labor market was approximately in equilibrium. In the 1st quarter of 2008, the unemployment rate averaged 5.0%. In the first quarter of 2016, the unemployment rate averaged 4.97%, virtually identical to 2008:1. The growth rate in RGDP over that 8 year period was 1.286%/year, just slightly above the 1.2% rate I estimated as the trend rate. And with labor force growth now slowing due to boomer retirements, I expect RGDP growth to slow a bit further, to 1.2% as the new normal.
Why was I able to see something the Fed missed? Because I don’t rely on past values of trend growth as being stable. In 2008 and 2009, the Fed erred by assuming that the natural interest rate was higher than it actually was. The performance of the economy was telling us that the Wicksellian equilibrium rate had fallen sharply, but the Fed simply refused to believe it. These low rates were inconsistent with decades of experience. The Fed assumed we’d eventually get back to normal, although now it’s becoming increasingly clear that low rates are the new normal.
Conclusion: Listen to the markets.
The same occurred with trend RGDP growth. For well over 100 years, America has averaged roughly 3% per year in trend RGDP growth. Thus the Fed assumed the economy would return to this growth path, after the recession. In fact, we are not doing so—we are in a “Great Stagnation” that (AFAIK) has no precedent in all of American history. Even the 1930s were totally different, as productivity growth was high and RGDP growth bounced back once the unemployment rate fell. But now we have unemployment having fallen all the way to 5%, and growth is still 1.29% over 8 years.
I first saw this coming back in 2011, because I noticed that we had a “job-filled non-recovery” not the jobless recovery postulated in the media. That is, the unemployment rate was falling quickly, but output growth remained well below 3%. Normally, growth is well above trend when unemployment is falling fast. That told me that RGDP trend growth had slowed sharply.
So should the Fed fire all their economists and hire me? Yes. But an even better solution is to fire all their economists and hire someone like Robin Hanson or Justin Wolfers to set up prediction markets for macro variables. Stop relying on government bureaucrats to predict the economy, and instead rely on the wisdom of crowds.
PS. Was the slow growth in Q1 (1.2% annual rate for NGDP) caused by the Fed’s decision to tighten policy in late 2015? Probably, at least in part.