Historically, no period of expansion has lasted longer than 10 years. Phases of full employment have quickly given way to recessions, with the economy only operating at full capacity for a few brief months before tipping into the next cycle of contraction and recovery. But as the current business cycle approaches its peak and unemployment continues to fall, the Federal Reserve now has an opportunity to adopt policies that could prolong the business cycle’s peak.
By almost every measure, the business cycle is rapidly approaching its pinnacle. After the sharp contraction caused by the 2008 financial crisis, the economy has been growing steadily and is now back to the brink of full capacity. And while there's still some slack remaining in the labor market, if job creation continues to outstrip population growth, full employment should arrive sometime next year.
For the past eight years, the Fed has maintained highly accommodative monetary policies. When near-zero interest rates proved insufficient to spur growth, the Fed twice turned to unconventional quantitative easing strategies, buying bonds in order to depress long-term interest rates and encourage private sector investment. Asset purchasing has since been tapered, but the recovery is still supported by very low short-term interest rates, and long-term rates are being held down by asset purchases by other key central banks.
When the economy is once again operating at its peak potential, artificially low interest rates could fuel imbalances and hasten the onset of the next recession. Which means the Fed may soon have to consider whether to normalize interest rates in an attempt to prolong the recovery.
Until recently, the Fed’s decision to maintain near-zero interest rates has been easy. At the recession’s lowest point, the true unemployment rate reached 12 percent; when millions of people were searching for jobs, the nation’s businesses needed support from record-low interest rates. With so much slack in the economy, inflation was a distant concern, and the Fed crafted policies with the goal of sustaining and protecting the fragile recovery.
Today, the economy is much more robust, and interest rate normalization is unlikely to derail growth. The official unemployment rate has dipped below 5 percent, and a more comprehensive measure of slack in the labor market—counting discouraged workforce dropouts and involuntary part-time workers—reveals a true jobless rate of around 6.5 percent. The labor market is crossing a threshold that the Fed has designated as the appropriate point for launching a series of interest rate hikes.
With inflation running well below the Fed's official 2 percent target, there's little immediate pressure to raise interest rates. But good news from the labor market has led the Fed’s Open Markets Committee to anticipate making two small rate hikes this year, with interest rates eventually climbing toward a 3 percent long-term goal.
Futures markets, however, are skeptical of normalization. Market forecasts call for no additional rate hikes this year and a long-term rate of slightly less than 2 percent, below the Fed’s official inflation target. This implies doubts about the recovery’s durability; markets seem pessimistic that the economy will ever thrive without an accommodative monetary policy.
Normalizing interest rates in anticipation of the coming peak could yield great benefits, but defying the market’s expectations will likely require strong resolve from the Fed. Every economic stumble in recent years, from stock market volatility to disappointing GDP growth, has been interpreted as the dawn of the next recession. But the recovery has proven resilient, and growth has not been derailed by periodic global headwinds. The time is rapidly approaching to adopt policies that will maximize the period of time in which the economy is operating at full capacity—indeed, prolonging the peak should enable households to build wealth, promote investment in productive enterprises and place the nation in a stronger position once the business cycle inevitably restarts.
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