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A Framework That Provides Clarity

During periods of “low visibility,” confusion reigns: for every indication of one trend, there seems to be a countertrend. The key is to glean from the collective wisdom of reliable leading indicators a clear signal that the economy is headed for a turn.

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May 21 2014

Burying the Lede

What is being gradually acknowledged – without any publicity or fanfare – is that long-term U.S. GDP trend growth, already estimated at around 2% to 2¼%, is converging towards its 2% stall speed. If so, almost every time GDP growth experiences a slowdown that carries it below trend, it will also fall below the recessionary stall speed.

In this context, a strategy of “pulling demand forward” makes little sense, whether in the context of fiscal or monetary policy. Such a plan requires sufficient potential demand from the future that could be pulled into the present.

Indeed, if there is a long-term pattern of falling trend growth, as we asserted nearly six years ago (August 2008), a “pulling forward” policy becomes increasingly untenable. As we noted last fall, this pattern of weaker recoveries, which Larry Summers referred to as “secular stagnation,” “dooms a policy of indefinitely bringing forward consumption, since demand will fall short when the future arrives” (November 2013).

Not to put too fine a point on it, but a fair question is whether estimates of potential GDP – and therefore the output gap – are at all reliable. As we observed over three years ago, “the output gap, which is the primary basis for monetary policy decisions by the Fed and most other central banks, is so badly flawed that it is virtually unusable… [being] subject to substantial revisions that could be of the same magnitude as the output gap itself… [E]ven the [Congressional Budget Office’s] calculations are based on relationships like Okun’s law that are increasingly untenable” (January 2011). If current official output gap estimates are too optimistic, there is little reason to expect any “catch up” this year or next.

In that light, it is instructive to review the evolution of official estimates of long-term trend GDP growth since the Great Recession. You’ll see that the FOMC consensus estimate of long-term GDP growth (i.e., over a five-to-six-year horizon) was around 2.65% to 2.70% until the fall of 2011 (with at least one estimate as high as 3%), when it was cut by several members. After repeated reductions, the last one being in March 2014, the consensus has come down to around 2.15% to 2.25%, i.e., a cut of about half a percentage point in less than two and a half years. At least one estimate is as low as 1.8%. This is quite a comedown.

The Congressional Budget Office (CBO) publishes the “official” estimate of potential GDP, defined as its “estimate of the maximum sustainable output of the economy.” Those potential GDP growth estimates for the long term (ten years out) have also been reduced lately, primarily due to “demographic trends that have significantly reduced the growth of the labor force.” Remarkably, they have been reduced sharply in a little over a year’s time, from just under 2.4% as of January 2013 to only 2.0% as of February 2014.

In sum, official long-term trend GDP growth estimates have been quietly lowered this year to the 2% to 2¼% range. This is more uncomfortable if one recalls a fast-forgotten Fed paper we first cited almost three years ago (June 2011), suggesting that a reasonable estimate of the U.S. economy’s recessionary “stall speed” was about 2%. While we do not endorse such a theoretical concept, we empirically confirmed that, when measured as suggested, the economy’s growth rate had virtually never fallen that low in the past half-century without a recession being already being in progress or set to begin in short order (December 2011).

The implications are profound -- long-term U.S. GDP trend growth is converging towards its 2% stall speed.

From where we sit, all of this is just another way of describing what happens during “the yo-yo years.” Indeed, this is quickly becoming an implicit endorsement of our longstanding “yo-yo years” thesis (March 2012) that predicts more frequent recessions for the advanced economies.

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