Our Recovery May Well Be the Envy of the World

We are nearing the fifth anniversary of the economic recovery from the Great Recession. This already makes it the fourth longest expansion of the postwar period, and it is not over yet. The forecasting community widely expects a strong bounce back in second quarter GDP following the weather-driven stall of the first quarter. Looking further ahead, most forecasts cluster around a GDP growth rate of 2.5 to 3.0 percent over the next several quarters. This above-trend growth rate would steadily reduce the gap between potential and actual GDP and correspondingly reduce the unemployment rate.

What leads to this relatively upbeat assessment? Over the past three years, GDP growth averaged only 2.0 percent a year and most economists and policymakers worried about downside risks and the need for policy stimulus. But things have gradually changed for the better. First, policy is more supportive. The fiscal consolidation that took place at all levels of government starting in 2010 is behind us. The federal budget is not tightening further. State and local budgets are under control and their employment levels are rising. And Federal Reserve policy continues to be aggressively easy.

Alongside this better policy environment, several other developments are improving prospects for private sectors demands. On the consumer side, households have deleveraged substantially and debt service burdens have declined to levels of decades ago. Exports are closely tied to GDP in our trading partners and most of them have healthier economies this year than last. The continuing boom in the domestic oil and gas industry is adding to business investment spending, both directly by the industry’s expansion and indirectly as low gas prices attract other manufacturers to locate here. Business investment more generally has not risen much in the slow expansion years. If GDP growth quickens as expected, business investment can be expected to rise faster, adding to that growth.

Looking beyond the next couple of years, current estimates of potential GDP–the GDP that would correspond to full employment in the labor market–are meaningfully below the estimates that prevailed before the Great Recession. This difference reflects the decline in labor force participation that the extended slump has brought about, and a lower estimate of the trend growth in productivity in the intervening years. Some of these changes, such as the low participation of younger cohorts who are staying in school longer, should be reversed by a return to high employment rates. Other changes, such as the lower participation of some older workers who lost jobs in the slump, are likely to be permanent for this cohort. But as future cohorts reach the same ages, their experience will have been different and their participation may be correspondingly higher.

With these parameters for the growth of potential, and with the near term forecast of 2.5 to 3.0 percent GDP growth, what can we expect over the next half decade or so? In practice, the Fed will choose when to tighten policy by closely observing how wages and prices are actually behaving. But as a ballpark estimate, the history of recent decades suggests an unemployment rate around 4.5 percent is sustainable full employment. And if that turns out to be right, the Fed will conduct policy so as to put the economy on its potential growth path with unemployment near that level.

Of course a lot can happen to throw off the best of forecasts. And shocks that cannot be anticipated will occur. But inflation risks, which have often complicated the conduct of policy in the past, have seldom been lower. And a transition to continued growth along the economy’s potential path is a reasonable central case for a middle run forecast. If we take 2 percent as the growth rate of potential for the next several years–a rate a bit slower than the CEA’s current estimate–then it would take a few years of expanding at the 2.5 to 3.0 percent rate forecasted here to reach full employment. After that, growth would be limited by the growth of potential. What started as a disappointingly slow recovery could end as a historically long expansion. That would not solve all the problems that have emerged concerning relative incomes and the concentration of unemployment; but it would provide a constructive environment in which to work on them. All in all, such an expansion today would be the envy of most of the world’s other advanced economies.