U.S. trend growth and monetary policy fashion

The Jakarta Post ,  Jakarta   |  Wed, 04/25/2007 3:20 PM  |  Opinion

Paul Donovan, London

Over the last ten weeks, meeting with clients all over the world (including in Indonesia), one question has led all the rest: ""what is the U.S. Federal Reserve going to do?"" Investors are strongly interested in opinions as to the future course of monetary policy in the United States because it is an outlook that remains uncertain. After a relatively long period where the path of policy has been relatively predictable, why are investors uncertain now?

Monetary policy, when reduced to basic principles, should be relatively simple to arrange. When an economy is overheating, and growing faster than it can sustainably manage, interest rates need to be raised in order to engineer a slower (and thus more sustainable) pace of growth. Conversely, if an economy is growing sluggishly and underperforming its potential growth rate, monetary policy should be accommodative in order to encourage a stronger pace of growth.

The problem with this simple view of policy is that it requires certain knowledge of whether an economy is overheating or not. This knowledge rests on the principle of ""trend growth"" -- the long term, sustainable rate of growth that an economy can bear. Most simple rules of monetary policy -- including the famous ""Taylor Rule"" devised by John Taylor (then of the U.S. Federal Reserve) -- rest on some kind of comparison of trend growth (or a proxy) with prevailing economic circumstances. The problem that the economists are currently wrestling with is whether trend growth around the world is constant, or changing.

The level of trend growth in an economy can be broken down into two components -- the growth of the labor force, and the growth of the productivity of the labor force (how much a worker produces, in effect). If the workforce doubles in size in a year, then (all things being equal) the amount that an economy could potentially produce in that year will also double. If the workforce works twice as hard over the course of a year (productivity doubles) then again the amount that an economy could potentially produce will also double.

However, the foundations of trend growth are not stable: Productivity and labor force growth can and do shift over time. These shifts in the underpinnings of trend growth will change the rate of trend growth itself, and in doing so create uncertainty about the future path of monetary policy.

In the United States, for the last decade at least, there has been an assumption that the trend rate of growth of the economy is somewhere around 3.25 percent. Indeed, there was a time when optimistic economists thought the level of trend growth could have been as high as 3.5 percent.

This most optimistic scenario flourished in the heyday of the dot com boom, when the internet was supposed to increase labor force productivity significantly. (As an aside, there is evidence that the productivity of economists was never increased by the internet, but instead diminished. The internet has facilitated communication, of course, and communication between economists tends to fuel disagreement and dispute, rather than productivity).

In the last few years, however, U.S. productivity has declined. U.S. labor productivity has tended to disappoint relative to longer term averages -- last year it fell about 0.25 percent below the average of the decade. Companies have been investing less that was expected, there are questions as to whether the U.S. labor force has the skills that companies are now seeking, and the result has been a decline in productivity growth rates.

Moreover, the growth of the U.S. labor force has also declined. Female participation in the U.S. labor force, almost uniquely in the industrialized world, has been falling back. Long term unemployment has been relatively persistent, and the long term unemployed do become so disillusioned that they leave the active workforce entirely.

These two shifts in the structure of the U.S. economy suggest that the trend rate of U.S. growth is now declining -- and that it probably stands at around 2.75 percent today. Moreover, it seems likely that the Federal Reserve believes in this decline in trend growth. If this is so, then it seems highly likely that the current market consensus of the future path of U.S. interest rates is wrong.

The consensus expectation for U.S. growth this year is 2.5 percent, and this growth rate is to be accompanied by two quarter point interest rate cuts. While this theory may hold if trend growth were 3.25 percent (because the economy at 2.5 percent would be operating some considerable way below potential), it is highly unlikely that the Fed would cut rates at all if it believes trend growth is 2.75 percent.

At UBS, we believe that the Fed will indeed reduce interest rates this year, but it will require a growth rate some considerable way below the current market consensus -- we believe a level of growth of around 2 percent. U.S. rate cuts will require a more significantly slowdown in economic growth than the market consensus currently supposes, if policy makers do indeed believe that trend growth is lower.

What does this mean for Indonesia? Uncertainty over U.S. policy does mean that financial markets, including markets in Indonesia, are subject to a degree of volatility. Uncertainty over U.S. monetary policy has undoubtedly contributed to some of the volatility financial assets have experienced over the last few months. The slower trend of U.S. growth in the long term also argues a degree of caution about depending on past performance as a guide to future growth from the U.S. as an export market. Trend growth is not just an abstract economic concept: It appears trend growth is suddenly coming into fashion in financial markets.

The writer is Managing Director of Global Economics, UBS Investment Research. This is a personal view. He can be reached at paul.donovan@ubs.com.

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