A while back I mentioned that there's no such thing as "immaculate inflation reduction." That is, the Fed doesn't magically bring inflation down with interest hikes. It slows the economy with interest rate hikes, and the slowing economy then brings down inflation. But the economy hasn't slowed recently, which means the Fed wasn't responsible for inflation going down.
But! Maybe the Fed did slow down the economy. Maybe the economy would have run even hotter if the Fed hadn't acted.
Maybe. But here's a remarkable chart that you don't see very often:
Potential GDP is the CBO's estimate of what GDP could be if the economy were running flat out. Obviously it's not sustainable for the economy to run above that for very long, but it's possible for limited periods. Check out the recent times when this briefly happened:
- 2000, at the tail end of the dotcom boom.
- 2006-08, the tail end of the housing boom.
- 2019, the tail end of the Obama-Trump expansion.
- 2023-24.
GDP has been running well above potential for the past four quarters. In other words, it's unlikely in the extreme that the Fed has meaningfully slowed down the economy. So far, anyway.
POSTSCRIPT: This really ought to be causing some head-scratching among economists. How is it that the Fed can sharply raise policy rates and yet the economy is running red hot two years later? It's a mystery.
It's a mystery? Here's a plausible explanation. Check the definition of "potential GDP"--the CBO's estimate of what GDP could be.
I suspect the CBO estimate does not distinguish between "fiscal stimulus" based on what kind of stimulus it is, instead using a simplistic calculation of deficit spending. But the type of fiscal stimulus we're experiencing in the Biden administration is what I would call "real stimulus"--i.e., the creation of new goods and services, ones that wouldn't be created by simply taking less taxes out of wealthy taxpayers' bank accounts through taxes. In other words, the government itself stimulating business and industry by increasing manufacturing demand, housing demand, construction demand, etc.
I suspect that this type of stimulus is much more "stimulating" than letting wealthy taxpayers keep more of their money so they can buy more luxury goods. I suspect this type of stimulus carries more of a "multiplier effect." Though I'm at a loss to figure out how to calculate the difference, I strongly believe that the CBO ignores that possible difference.
Very true--money going into the hands of workers that spend it cycles through the economy much more so than money being squirreled away in offshore accounts to avoid the tax man.
the fed only affects the price of credit
and this isn't 1946; we aren't expanding production to house/feed/clothe/educate a rapidly expanding population (although we could use a few more houses on the coasts)
now that boomers have retired, they don't need credit, and a lot of them are flush with cash
a lot of our big companies are also sitting on piles of cash; apple/google/etc aren't reliant on debt to fund a new idea like AI (although trump media would take your money if you're
stupid enoughwilling to give it to them)globally, the chinese expansion has apparently run its course and is entering the middle-income trap, while the US has seen a bit of a bump in our industrial sector
and the long hard slog of the 2008 recovery was as much about billionaires/conservatives wanting the economy in the shitter to destroy obama's 2012 chances as it was about any real economic bottlenecks
chips act, ira and china opening up again are countering the high rates
i see trump media has fallen to a new post-merger low today
yet another reason the big orange toddler has been so tetchy as of late
Pro tip: provide a legend and not make the reader figure out which line is which by reading the text. Tufte would not approve of the visualization
A pro would find it obvious that something called "potential GDP" would be a smooth line and a plot of "real GDP" would fluctuate from year to year. Seems more like an "amateur tip" to me.
CBO eventually downgraded potential GDP following the hysteresis of the Great Recession. I'd be curious to see the trend line from, say, 1990-2007 extended to present and see how that compares with actual GDP. It could just be a matter of Potential GDP being too conservative. Much the same way 5% unemployment is evidently not NAIRU "full" employment.
I propose that Economics must be placed firmly in the camp of Liberal Arts no matter how many numbers and charts are produced - it ain't science.
Pseudosciences sometimes mature and become real sciences. Astrology eventually developed into astronomy, and alchemy became chemistry. What do you suppose will become of economics?
Hello??? Earth to Kevin...anyone home?
"Potential GDP is the CBO's estimate of what GDP could be if the economy were running flat out."
What part of "estimate" is difficult for you to understand? For that matter, GDP is an estimate from surveys. You can't actually measure GDP. So when two estimates are near each other but one is slightly higher, do you conclude:
1. OMG!! That line can't be higher than the other line without some kind of disaster looming!!
or
2. Meh. The error bands of these estimates are more than enough to account for the difference. Nothing to see here. Move along.
Or conclusion 3-Estimated GDP has been running well above estimated potential GDP for the past four quarters. In other words, it's unlikely in the extreme that the Fed has meaningfully slowed down the economy. So far, anyway.
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This seems like a reasonable conclusion.
There are lots of other indicators, such as unemployment rates, that point to marked slowing. It pays to look at the whole picture and not just one indicator.
Frank
To me, there's too much noise in some of the standard parameters. Unemployment is affected by numbers of available workers which can be influenced by immigration.
Then theres this - the standards of old are now stale. It USED to be that a 5% unemployment rate was a GOAL. No more. We got so used to sub 4% that it seems that has become a benchmark of sorts.
House building is another one. With our birthrates declining so badly is housing starts a viable metric? (also think about corporate house buying these days).
I'm getting an uneasy feeling about the state of our economy.
On the one hand our debt is being serviced fairly pain free but OTOH, ANY debt is wasting money.
Old metrics need to be re-thought, I believe.
Agree with all of this, which was the point of my original comment. Hand wringing over a tiny difference between estimates of GDP and potential GDP is silly. Every month we see people poring over the latest economic numbers trying to divine the future. It reminds me of so many shamans poring over the entrails of a sheep. An economy the size of the US just doesn't change that fast, and monthly data is almost useless.
However, while benchmarks can become outdated over time, directional trends can be useful. And you need to look at the whole picture, not just one or two indicators, and over a period of time longer than a month. Right now the whole picture seems to be pointing to some slowing, but not panic-worthy. It's almost certain the Fed will reduce interest rates by 0.5% next month. Probably more easing in the future. Predicting doom is fashionable, and people somehow think it makes them look smart. I'm not worried at all.
I would presume because foreign nationals and governments shield their wealth by purchasing American assets.
I keep saying that interest rates are just not that high. Inflation is running about 3% year over year, which means 5% interest rates only give a 2% real rate of return. That's just NOT high. Current rates are about neutral, neither stimulating the economy nor slowing it.
Year over year is telling you the cumulative inflation over the last year. Looking at shorter time periods gives much closer to 2%. Historically, real returns on risk-free investments (read: treasuries) have been much less than 1%. Interest rates are high.
My impression is that historically, real rates of risk free return have been in the 2-3% range.
Money is not a real resource like a factory or a mine or a farm or a workforce. But it is a tool that's required for these real resources to be employed with maximum efficiency. Imagine if all money vanished tomorrow. We'd still theoretically have the same capacity for economic output—those real resources haven't vanished—but we'd obviously see economic activity plunge, because the transition to barter would be chaotic and ruinous.
Money hasn't vanished, but if the Fed's actions have succeeded in making it scarcer, perhaps the potential of the economy has, in fact, been reduced. After all, the most interest rate sensitive parts of the economy tend to be associated with the development of property, and some of this development feeds directly into economic potential. A hotel or apartment building can't contribute to GDP unless it gets built.
This:
"GDP has been running well above potential for the past four quarters. In other words, it's unlikely in the extreme that the Fed has meaningfully slowed down the economy. So far, anyway"
Is simply wrong. It is statement arising from
A. an assumed conclusion (If Fed raises rate then economy goes down) that is predicated on a rather simplistic concept of what Central Bank policy does (and simplistic mechanistic view on that) and
B. a logical fallacy, really the excluded middle.
It is entirely possible and indeed well within reason given comparators one can look at internationally (God forbid Americans do such a thing) that with the combined accumulated economic tail winds of enormous *global accumulated savings* in pandemic and the American double stimulus that economic stimulus would be even hotter and see more inflaitonary pressure. One can not simply assert if not in recession (from the a priori conclusion that is the result) that this means no impact, that is simply unsupported as a conclusion (somewhat along the lines of asserting a car in a car wreck was going 100 kph therefore no brakes were applied, from an a priori idea that application of breaking must result in a lower speed, which is not logical).
Possible of course does not make it a fact of course.
The crank-level rants from Drum on Fed are quite the disappointment. The utter illogic of constantly asserting lower rates are needed to avoid recession but that higher rates did nothing to slow economy, etc shows a fundamental incoherence and illogic....
Consider the following possibility.
The size of the federal debt is large enough that high interest rates cause a stimulative rise in interest payments which counters the slowdown expected from the higher interest.
Since this mechanism simply results in a transfer of more wealth to the wealthy without achieving the desired slowdown from higher rates, it makes sense to advocate for reducing rates and maybe raising taxes instead.