Overheating a car, a laptop or an appliance can have catastrophic consequences, so the prospect of the U.S. economy “overheating” may well cause alarm.
The question of whether the economy is running too hot returned to the news cycle this month as the new chairman of the Federal Reserve took his seat. Jerome Powell told the Senate Banking Committee that while the Fed may increase interest rates at a faster pace in 2018, he does not believe the economy is in danger of overheating.
There is no argument that the U.S. economy has been expanding for a long time. So what is the difference between a strong economy and an overheated one? In other words, how much expansion is too much?
First, it is worth defining what an “overheating economy” actually means to economists before trying to answer the question. In simplest terms, an overheating economy is an economy expanding at an unsustainable rate. Eventually, demand for goods and services will outstrip the economy’s ability to meet that demand, leading to inefficiency and inflation. History shows that no economy can grow rapidly forever without consequences; the mismatch between supply and demand in an overheated economy slows economic growth and could even push the economy all the way into a recession.
Unfortunately, a nation’s economy does not come equipped with a handy “check engine” light, so economists consider a variety of factors when attempting to evaluate whether an economy is in danger of overheating. One of the clearest factors is a significant rise in inflation. Central banks will often raise interest rates in order to keep inflation under control by moderating spending and borrowing. Unfortunately for central bankers, curbing inflation this way takes time, making interest rates a poor emergency brake.
The other significant symptom pointing toward overheating is abnormally high levels of consumer confidence. The Consumer Confidence Index measures optimism through a monthly five-question survey covering consumer opinions of both current and future economic conditions. Confident consumers tend to be more willing to make big-ticket purchases like homes and vehicles, and to take chances on starting new business ventures. These sound like positive economic developments, and they are. But if you are worried about demand outstripping the capacity for supply to keep pace, unusually high confidence can serve as a warning sign.
Given these indicators, we can return to the current state of the U.S. economy. Certain observers have asked whether it was overheating for years, since a nine-year expansion is quite a long upward streak. Certain measures have improved even more sharply within the past two years or so. Goldman Sachs predicted last November that the Fed would need to intervene in 2018 to prevent overheating, especially if unemployment fell further.
Worries about overheating have been growing recently because of the GOP’s tax reform, especially the major cuts it incorporates. In combination with spending increases slated for the next couple of years, these cuts may bolster individual and business spending, in turn potentially raising inflation. Historically, legislators have stimulated struggling economies, not booming ones. Stimulating an already strong economy could kick-start inflation. The stimulus also potentially puts fiscal and monetary policy at odds, since the Fed is poised to raise interest rates as many as four times in 2018.
That said, Powell’s confidence that the economy is not about to overheat rests on a solid foundation. For now, while inflation has risen in recent months, it remains well below the Fed’s 2 percent target. If you exclude the volatile categories of food and energy prices, prices rose 1.5 percent between January 2017 and January 2018.
Moreover, as economist Jared Bernstein observed in a column for The Washington Post, the type of inflation that indicates an overheating economy isn’t just a matter of higher prices. It’s a matter of prices spiking above historical averages. Since inflation has been unusually low for a long time, rising inflation is, to a point, simply a return to a more normal state of affairs.
If unemployment is so low – 4.1 percent by the latest Bureau of Labor Statistics report – and interest rates are also still low by historical standards, why has inflation stayed relatively tepid? Economists don’t agree. It could be that there are potentially significant numbers of Americans who have stopped looking for work, and therefore do not show up in unemployment measures, who could be tempted back to the labor market under the right circumstances. Businesses may also be increasing productivity through increased automation. Alternately, slow economic growth elsewhere in the world could be holding U.S. inflation back. Some economists have identified short-term circumstances, such as the “Amazon effect,” that may distort the data.
We may find out if a potentially untapped corner of the labor market is a factor if wages begin to grow, potentially attracting workers. Rising wages can contribute to inflation, but by this measure, overheating remains unlikely for now. While the national unemployment rate remains very low, wages have grown only sluggishly for years. Powell commented in his Senate remarks that the surprising slowness of wage growth is a major factor in his confidence that the economy is in no danger of overheating.
The theory that there is still slack in the labor market is also supported by the jobs report that arrived last week. In addition to a steady unemployment rate, February brought an additional 313,000 new jobs, the largest monthly gain since July 2016. While we should not extrapolate too far from a single month’s data, these results bolster the argument of those who believe the supply of labor could continue to grow under the right conditions.
While inflation remains low, we are seeing a spike in consumer confidence. In October, the University of Michigan’s consumer-sentiment index hit its highest level since 2004. Household saving rates fell sharply in recent years, from more than 6 percent of gross domestic product in 2015 to 3.2 percent of GDP in 2017. Low interest rates and a strong job market are encouraging individual Americans to spend relatively freely. In the absence of serious inflation, however, consumer optimism is less a serious warning sign and more a rational reaction to strong economic circumstances.
As I have written before, another recession is inevitable sooner or later. That is simply how economies work over time. The U.S. economy may even overheat before it happens. But based on the indicators available today, it seems likely that Powell is right. Sometimes a strong economy is just a strong economy. Businesses and consumers should enjoy it while it lasts.
Posted by Paul Jacobs, CFP®, EA
Jerome Powell in 2016. Photo courtesy the Federal Reserve.
Overheating a car, a laptop or an appliance can have catastrophic consequences, so the prospect of the U.S. economy “overheating” may well cause alarm.
The question of whether the economy is running too hot returned to the news cycle this month as the new chairman of the Federal Reserve took his seat. Jerome Powell told the Senate Banking Committee that while the Fed may increase interest rates at a faster pace in 2018, he does not believe the economy is in danger of overheating.
There is no argument that the U.S. economy has been expanding for a long time. So what is the difference between a strong economy and an overheated one? In other words, how much expansion is too much?
First, it is worth defining what an “overheating economy” actually means to economists before trying to answer the question. In simplest terms, an overheating economy is an economy expanding at an unsustainable rate. Eventually, demand for goods and services will outstrip the economy’s ability to meet that demand, leading to inefficiency and inflation. History shows that no economy can grow rapidly forever without consequences; the mismatch between supply and demand in an overheated economy slows economic growth and could even push the economy all the way into a recession.
Unfortunately, a nation’s economy does not come equipped with a handy “check engine” light, so economists consider a variety of factors when attempting to evaluate whether an economy is in danger of overheating. One of the clearest factors is a significant rise in inflation. Central banks will often raise interest rates in order to keep inflation under control by moderating spending and borrowing. Unfortunately for central bankers, curbing inflation this way takes time, making interest rates a poor emergency brake.
The other significant symptom pointing toward overheating is abnormally high levels of consumer confidence. The Consumer Confidence Index measures optimism through a monthly five-question survey covering consumer opinions of both current and future economic conditions. Confident consumers tend to be more willing to make big-ticket purchases like homes and vehicles, and to take chances on starting new business ventures. These sound like positive economic developments, and they are. But if you are worried about demand outstripping the capacity for supply to keep pace, unusually high confidence can serve as a warning sign.
Given these indicators, we can return to the current state of the U.S. economy. Certain observers have asked whether it was overheating for years, since a nine-year expansion is quite a long upward streak. Certain measures have improved even more sharply within the past two years or so. Goldman Sachs predicted last November that the Fed would need to intervene in 2018 to prevent overheating, especially if unemployment fell further.
Worries about overheating have been growing recently because of the GOP’s tax reform, especially the major cuts it incorporates. In combination with spending increases slated for the next couple of years, these cuts may bolster individual and business spending, in turn potentially raising inflation. Historically, legislators have stimulated struggling economies, not booming ones. Stimulating an already strong economy could kick-start inflation. The stimulus also potentially puts fiscal and monetary policy at odds, since the Fed is poised to raise interest rates as many as four times in 2018.
That said, Powell’s confidence that the economy is not about to overheat rests on a solid foundation. For now, while inflation has risen in recent months, it remains well below the Fed’s 2 percent target. If you exclude the volatile categories of food and energy prices, prices rose 1.5 percent between January 2017 and January 2018.
Moreover, as economist Jared Bernstein observed in a column for The Washington Post, the type of inflation that indicates an overheating economy isn’t just a matter of higher prices. It’s a matter of prices spiking above historical averages. Since inflation has been unusually low for a long time, rising inflation is, to a point, simply a return to a more normal state of affairs.
If unemployment is so low – 4.1 percent by the latest Bureau of Labor Statistics report – and interest rates are also still low by historical standards, why has inflation stayed relatively tepid? Economists don’t agree. It could be that there are potentially significant numbers of Americans who have stopped looking for work, and therefore do not show up in unemployment measures, who could be tempted back to the labor market under the right circumstances. Businesses may also be increasing productivity through increased automation. Alternately, slow economic growth elsewhere in the world could be holding U.S. inflation back. Some economists have identified short-term circumstances, such as the “Amazon effect,” that may distort the data.
We may find out if a potentially untapped corner of the labor market is a factor if wages begin to grow, potentially attracting workers. Rising wages can contribute to inflation, but by this measure, overheating remains unlikely for now. While the national unemployment rate remains very low, wages have grown only sluggishly for years. Powell commented in his Senate remarks that the surprising slowness of wage growth is a major factor in his confidence that the economy is in no danger of overheating.
The theory that there is still slack in the labor market is also supported by the jobs report that arrived last week. In addition to a steady unemployment rate, February brought an additional 313,000 new jobs, the largest monthly gain since July 2016. While we should not extrapolate too far from a single month’s data, these results bolster the argument of those who believe the supply of labor could continue to grow under the right conditions.
While inflation remains low, we are seeing a spike in consumer confidence. In October, the University of Michigan’s consumer-sentiment index hit its highest level since 2004. Household saving rates fell sharply in recent years, from more than 6 percent of gross domestic product in 2015 to 3.2 percent of GDP in 2017. Low interest rates and a strong job market are encouraging individual Americans to spend relatively freely. In the absence of serious inflation, however, consumer optimism is less a serious warning sign and more a rational reaction to strong economic circumstances.
As I have written before, another recession is inevitable sooner or later. That is simply how economies work over time. The U.S. economy may even overheat before it happens. But based on the indicators available today, it seems likely that Powell is right. Sometimes a strong economy is just a strong economy. Businesses and consumers should enjoy it while it lasts.
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