The Fed is “patiently” on hold, according to official pronouncements, because of downside risks to the economic forecast. These downside risks are the result of the previous tightening in U.S. financial conditions (lower equity prices, higher rates) and weaker overseas activity in Europe and China.
While we continue to expect the Fed to remain on hold through 2019, followed by a cut in interest rates, there is still one scenario in which policymakers raise rates and where financial conditions do not significantly deteriorate.
For this scenario to materialize, there would need to be a substantial rise in productivity growth. The good news is that the Fed’s on-going “patience” increases the probability of such a development occurring.
Productivity growth has been very weak in this business cycle. Output per hour, as it is technically defined, has been growing barely more than 1 percent over the past few years. This is about half of its long-term average.
Given that the rate of productivity growth determines profitability, and eventually, living standards, this trend is troubling. But, productivity was up 1.9 percent and 1.8 percent over the last four quarters. This is the fastest pace in nearly three years.
Nevertheless, a determination of whether the long-awaited upswing in productivity has finally arrived is still premature. We will need at least another few quarters to see if this nascent upswing turns into something more substantive.
Most promising is that the Fed does not appear to be in any hurry to raise interest rates. This is key, because the probability that higher interest rates choke off the economy has significantly fallen. This was why financial markets tightened so dramatically last year.
By waiting to see if the trend of slowing productivity growth has finally reversed, the Fed may actually be able to raise rates more down the road. This is because faster productivity growth necessarily means faster economic output growth, and faster economic output growth implies higher interest rates.
Why? This is simply due to the need for a higher interest rate to balance the supply and demand of loanable funds. This close relationship between the natural rate and fed funds rate is visually apparent when both series are graphed together.
In other words, when real GDP growth picks up, consistent with faster productivity, interest rates rise to equilibrate available capital and profitable investment projects. However, this is the opposite of today’s environment, which has led to low productivity and an excess of saving over investment.
Low interest rates are a function of weak economic activity. Some economic observers have dubbed this phenomenon as “secular stagnation.”
However, we are more sanguine. Productivity cycles can be quite long, where changes in the underlying trend are noticeable only after the fact.
Specifically, advances in artificial intelligence, robotics and machine learning, just to name a few technologies, all could eventually lead to a step-up in output per hour. The latest productivity uptick could be the start of a new higher trend rate of growth.
With inflation running at less than 2 percent, there is no reason for the Fed to raise interest rates further at this point. Instead, policymakers can, and should, wait to see if a long-awaited upward trend in productivity manifests.
If it does, then the Fed can raise interest rates in a way that would not be destabilizing. In other words, higher interest rates would be associated with a stronger economy, which would be welcomed news for equity investors.
Joseph LaVorgna is the chief economist for the Americas at Natixis, an international corporate and investment banking, asset management, insurance and financial services arm of Groupe BPCE, the 2nd-largest banking group in France.