Back to Normal
Wednesday, 13 February 2013
It may seem sluggish compared to the recent past, but economic growth is right on trend.
Although the economic recovery has been under way for more than three years, it often seems lacking in gusto. The growth rate for gross domestic product (GDP), the broadest measure of economic activity, has averaged just over 2 percent annually in the years since the recession’s end. This has not been enough to pull the jobs market out of its doldrums. Unemployment now stands at 7.9 percent, and labor force participation has fallen to levels not seen in more than 30 years. People are literally bailing out of the economy.
The GDP growth rate also compares unfavorably to some periods in the recent past. Annual growth averaged 2.6 percent from 2002 to 2007 and 3.8 percent from 1992 to 2000.
But the numbers are deceiving. Current growth is close to the norm and may be the best our economy can do. Two factors are making the current growth rate seem below normal when it actually isn’t. The first is related to short-term conditions in an important market: housing. The boom that immediately preceded the recession created a growth bubble that is distorting our perception of the recovery.The second factor is connected to fundamental structural developments in the broader economy. The structure of the U.S. economy has changed, and its potential for growth may be lower now than it was before.
Both of these factors work together. The result: The current 2 percent growth rate may be as good as it gets for a while.
AIER’s indicators of business-cycle conditions support this view. In terms of the normal ebb and flow of business activity, the recovery is playing out as it should. The economy has been expanding since the third quarter of 2009 and has all the elements in place for continued growth.
Each group of AIER business-cycle indicators has scored well above 50 points, which means it is highly probable that economic activity is consistent with expansion. That is, all our measures are safely in positive territory.
AIER economists find that 73 percent of our leading indicators are on an expansionary trend (eight out of 11 for which a trend is apparent). In addition, the cyclical score of leaders, which is based on a separate, purely mathematical analysis, stands at 78.
Both the coincident and lagging indicators confirm the description of the economy’s relatively good health. In both cases, 100 percent of the indicators are trending upward. Their cyclical score stands at 98 for coinciders and 87 for laggers. (For a closer look at AIER’s business-cycle indicators, see the appendix that begins on page 4.)
The Bureau of Economic Analysis’s preliminary report on the fourth quarter of 2012 does not change our assessment that the economy is in good shape. According to the BEA’s numbers, real GDP declined at a 0.1 percent annual rate during the quarter.
Preliminary BEA numbers are essentially first estimates. Actual GDP growth in the fourth quarter could lie anywhere between a 0.9 percent increase and a 1 percent decrease. A more accurate picture of the quarter will emerge with new data and refined estimates over the next two months. We expect that it will show a growing economy.
Moreover, the economy was hit hard during this period by two storms: Hurricane Sandy and December’s fiscal impasse in Washington. We expect to see a rebound in growth early this year as the nation gets back on its feet. Consumer spending, the main driver of the U.S. economy, continues to expand at a solid pace. It grew at a 2.2 percent annual rate in the fourth quarter, up from 1.6 percent the quarter before.
Potential GDP is the maximum output an economy can sustain when productive capacity is being utilized at a high rate and almost everyone who wants a job can find one. Over the long term, actual GDP growth averages out to match potential growth. (See Chart 3, bottom right.) For short periods, people can work unusually long hours and machines can run beyond rated capacity. When an economy is using a particularly high amount of resources in this way, actual GDP can exceed potential output. But eventually people and machines break down. The economic engine must return to its long-term potential. The years of the housing bubble and its aftermath are but one example of this mechanism.
Chart 2 at right maps U.S. GDP growth since 1947. During this time, the economy frequently exceeded its potential GDP. In the late 1990s, the economy was growing so fast that unemployment fell to record lows, dipping below 4 percent in 2000. Such a low level is extremely rare. Jobs were so plentiful that any person who lost a job could quickly find another. The median duration of unemployment was close to five weeks. Many people also held more than one job. A level of labor utilization this high cannot be sustained for long.
The housing bubble, which probably began in the early 1990s and ended in 2007, was also a period of unusual utilization of resources besides labor, such as machinery, lumber, and factories. From 1991 to 2006, the number of new houses built in the U.S. grew rapidly. By 2005, more than 2 million new homes were being built each year—a level rarely seen before. Firms poured more and more resources into housing and related industries.
Eventually, the bubble had to pop—and GDP plunged accordingly.
Since the start of the recovery, GDP has been rising at about the same speed as the potential GDP trend, as Chart 2 above right shows. This suggests that the growth we are experiencing is actually the norm.
The norm for the growth rate of the economy’s output changes over time. That may be happening now. According to a study released last November by the Congressional Budget Office, our rate of potential growth has slowed down in recent years. And it will continue to be this slow for years to come.
The jury’s still out on these findings, but several long-term demographic trends may have lowered the economy’s capacity for growth. Retiring baby boomers are reducing the rate at which our potential labor force can expand. And the labor force participation rate for women has leveled off in the last decade after rising since the early 1960s. With fewer people available for employment, the rate at which the GDP can grow necessarily slows.
The CBO estimates that potential GDP growth will hover below 2 percent per year through 2015. After that, growth will accelerate slightly, rising to about 2.5 percent.
Against this backdrop, 2 percent GDP growth looks respectable. The expansion may not be roaring, but as the healthy economy described by AIER’s indicators shows, the recovery is on track.