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Markets and Economy

Measuring the Economy’s True Potential

Understanding the economy’s potential output can serve as a reference point for its overall state—and with the recovery in its ninth year, current employment and inflation rates show us how much more expansion is sustainable.
Jim Glassman, Head Economist, Commercial Banking
December 20, 2017

In the economy’s ninth year of recovery from the Great Recession, its potential output indicates how much more growth is possible this business cycle. Potential output can be understood as the maximum amount of goods and services an economy can produce while maintaining stable inflation, although it’s not precisely measurable. The unemployment rate has now fallen within the range considered full employment, yet inflationary pressure remains low—a sign that there’s still room for additional economic expansion.

Economy Expanding to Its Full Potential

When the workforce is fully employed and businesses have maximized their investment in productivity-enhancing technologies, the economy is thought to be operating at full capacity. At that point, any further increases in aggregate demand will generate inflationary pressure, prompting a rise in interest rates.

The economy will naturally gravitate toward its full potential as the expansion continues. A significant amount of slack was left over from the last recession; even nine years of above-trend growth haven’t been enough to bring the recovery to completion. Job creation continues to outstrip the number of workers entering the job market, yet businesses are still able to fill new positions.

Until aggregate demand finally exceeds the economy’s potential capacity, the current expansion is likely to continue uninterrupted.

Where Is the Top of the Business Cycle?

In past business cycles, unemployment has served as a reliable barometer for the amount of slack remaining in the economy. Historically, the economy has neared its full potential when the supply of available workers dwindled. When growing businesses can no longer staff appropriately, periods of expansion reach their natural limit.

However, the exact level of unemployment that marks the return of full employment is not set in stone—different business cycles have seen wide variations. In the 1970s and 1980s, a 5 to 6 percent unemployment rate marked the lower bound. But in the 1990s, headline unemployment fell below 5 percent for four straight years, eventually falling to a three-decade low of 3.8 percent when the business cycle peaked in April 2000. At the peak of the last business cycle, the unemployment rate spent two years below 5 percent.

Today, headline unemployment has held below 5 percent for 19 months without generating significant inflationary pressure. In response to this shifting baseline, the Federal Reserve’s Summary of Economic Projections has revised its assumptions about the lowest sustainable level of unemployment.

Further complicating matters, the headline unemployment rate doesn’t reflect every source of slack in today’s labor market. In recent years, millions of discouraged workforce dropouts have begun to return to the job market, but many have yet to come back; they will likely return as the need for workers continues to rise. This rising demand for workers could encourage some students to leave school early to enter the workforce, and higher wages may entice others to postpone retirement. Millions of part-time workers may also take on additional hours as the labor market continues to tighten.

Capital investment also plays a role in bringing the economy to its full potential. Investments in technology and training can lift worker productivity, providing an avenue for potential growth beyond increasing the size of the workforce.

Ultimately, rising inflation will mark the end of above-trend growth. When prices start to increase, the Federal Reserve will be forced to hike interest rates more aggressively to keep the economy from overheating. The Fed’s gradual pace of rate normalization is an attempt to prolong this process, keeping the economy running near its full potential for as long as possible.

Expecting Continued Growth

The current unemployment rate of 4.1 percent is quite low by historical standards, but the lack of inflationary pressure is a clear sign that the economy’s true potential has not yet been realized. With fiscal stimulus in the pipeline, forecasts call for a further decline in unemployment, rising asset prices and accommodative monetary conditions continuing for the foreseeable future. No one can know exactly how much growth potential is left in the economy, but there is no reason to believe it’s running out anytime soon.

View our economic commentary disclaimer.

 

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