The economy has a speed limit, no matter what politicians say

The economy has a speed limit, no matter what politicians say
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The Department of Commerce’s Wednesday estimate for 2017’s fourth quarter GDP growth contains a small dose of optimism for 2018’s prospects. The growth estimate was lifted to 2.9 percent from an earlier estimate of 2.7 percent.

The positive nudge came primarily from higher levels of consumer spending and business investment. These healthier Commerce numbers support the Federal Reserve Board’s recent optimistic revision to GDP growth for 2018. At the March meeting, the board lifted the estimate to 2.7 percent from its September 2.0 percent.

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Has the sleepwalking economy finally woken? Should we expect to see 3.0-percent growth over the next 12 months? The economy is surely moving at a quicker pace. Income tax cuts and regulatory reform together are making a difference.

 

Somewhat offsetting the good news, however, the Commerce Department reported that the fourth quarter GDP price index rose 2.5 percent, versus 1.7 percent in the third quarter. Inflation has returned.

Of course an economy has a speed limit — no matter how much government leaders might think otherwise. Even with occasionally higher quarterly estimates, what an economy can do on a sustained basis is determined by how many people go to work each day and how productive they are when working.

Just two variables determine the limits of GDP growth, mind you. Those are growth in labor productivity and growth in the labor force. This iron law was first called to our attention by none other than Adam SmithDavid (Adam) Adam SmithOvernight Defense: Mattis dismisses talk he may be leaving | Polish president floats 'Fort Trump' | Dem bill would ban low-yield nukes Dems introduce bill to ban low-yield nukes Dems seek ways to block Trump support for Saudi-led coalition in Yemen MORE himself.

Writing in “The Wealth of Nations” in 1776, Smith pointed out that the degree of wealth in a nation is “regulated by two different circumstances; first by the skill, dexterity, and judgment with which the Labour is generally applied; and secondly, by the proportion between the number of those who are employed in useful labour, and that of those who are not so employed.”

So how do the revised Commerce and Fed GDP growth estimates compare with recent data on labor productivity and labor force growth? Not so well, I’m sorry to say.

The most recent data from the Federal Reserve Bank of St. Louis sets productivity growth for 2017 at 1.24 percent on a year-over-year basis. The same source shows 2017 labor force growth at 0.70 percent. Added together, we get about 1.94 percent real GDP growth for 2017. In other words, things are sort of tight.

Of course, productivity does vary from quarter to quarter and new business investment can improve the number. It’s also true that the labor force can show more growth. 

Even so, we should not expect to see sustained 3.0 percent growth any time soon, and we should look out for higher inflation in late 2018 and in 2019. Ultimately, of course, inflation, defined as too much money chasing too few goods, is determined by what monetary authorities do. 

What the Fed does about interest rates and money supply is crucial. The Fed has already signaled that more interest rate increases are to be expected, but will that be enough to calm inflationary forces now working away in the economy? Or will the increases be too much, thereby pushing the awakened economy into another sleepwalk or worse? 

Encouraging data on economic prosperity and early signs of inflation tell us the economy is at a turning point.  Let’s hope the turning point does not turn into a downturn.

Bruce Yandle is a distinguished adjunct fellow for the Mercatus Center at George Mason University, dean emeritus of the Clemson College of Business and Behavioral Sciences and a former executive director of the Federal Trade Commission. His March 2018 Economic Situation report may be downloaded here.