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August 19, 2009

How fast can the economy grow?

The recession may be ending (and may, in fact, have ended, according to the majority of economists recently surveyed by the Wall Street Journal) but, as Friday's consumer confidence report suggests, the uncertainty about the course of future growth is far from resolved. The most recent consensus forecast from the panel assembled for the monthly Blue Chip Economic Indicators does suggest a nice bounce back into positive growth territory, bringing to an end a four-quarter run of gross domestic product (GDP) contraction.

081909

What remains interesting, however, is the range of disagreement about just how fast the recovery will be. The upper and lower black lines in the chart above delineate the 10 most optimistic forecasts (the upper lines) and the least optimistic forecasts (the lower lines) among the Blue Chip panel's 51 economists. Most interesting is the fact that some collection of theses economists are, in any given quarter, guessing that growth will not break a 2 percent annual pace before we exit 2010.

That uncertainty is compounded by an even more consequential uncertainty, lucidly emphasized recently by Menzie Chinn (here, here, and here): How fast can we grow before straining the economy's capacity? In other words, is slow growth the best we can expect given the economy's current potential?

The output gap—the difference between the current level of GDP and estimated potential—has long been standard fare in policy analysis. Over at iMFdirect, the International Monetary Fund's blog, Ajai Chopra explains why we care:

"What would be merely a curiosity during better times—after all, potential output is a largely abstract concept measuring the level of output an economy can produce without undue strain on resources—has become a particular worry in the context of the global economic crisis…

"Right now, budget planners across Europe are scrambling to estimate the strength of the blow the crisis has dealt to public finances, and not knowing the growth potential of their economies greatly complicates their task. If they overestimate potential growth, they would underestimate the need for fiscal adjustment once the crisis has dissipated, raising thorny issues of fiscal sustainability in the longer run.

"Central bankers, too, are looking for guidance on the path of potential output. Their decision on when to start winding down current crisis policies depends on the difference between potential and actual output, the so-called output gap. If the output gap is closing faster because of a drop in potential, policymakers might decide to increase interest rates a little earlier and a little higher to prevent  inflation from rising."

Economists also do not lack methods for estimating the output gap and, just in case the field is not crowded enough, Atlanta Fed economist Jim Nason has done some investigating of his own. Jim looked at a variety of statistical estimates of the output gap and arrived at what is now a pretty familiar conclusion. To wit, there is substantial variation in output gap estimates across the different methods, and I do mean substantial: The gap estimates for the second quarter of 2009 range from –0.5 to nearly –11 percent depending on which method is used. In other words, some methods imply the gap is very large, others say the gap is rather small.

I am tempted to invoke the ancient economists' chant, "noh-bah-de-noz," but real-life policymakers don't have that luxury. So we delve in the details and try to sort out what seems like the best approach. (If you have a technical bent, you can do the same with Jim's estimates by following this link.) As we sort it out, though, Ajai Chopra gives some sound advice:

"As for central bankers, they should also act on the information they have, although researchers such as Athanasios Orphanides (now Governor of the Central Bank of Cyprus and member of the ECB's Governing Council) have sensibly suggested that central banks should tread carefully by reducing the importance of the output gap in their decision making.

"More generally, policymakers—be they in the central bank or in the ministry of finance—would do well by communicating their assumptions about potential output growth to the public."

With that in mind, I will leave you with the recent communication on the subject offered by Federal Reserve Bank of Atlanta President Dennis Lockhart:

"Many observers see substantial slack in the economy that could persist for some years. Economists' more formal term for slack is "output gap." We at the Atlanta Fed see a meaningful output gap developing, but in our view it is smaller than would normally be associated with the weak pace of growth we expect over the next couple of years because all the obstacles to the natural pace of growth already mentioned have brought down the economy's potential for the medium term."

So, as President Lockhart indicates, mark us down, for now, on the low end of output gap scale.

Update: The San Francisco Fed's John Fernald and Kyle Matoba offer some related thoughts in the newest edition of the Bank's Economic Letter (hat tip to Econbrowser).

By David Altig, senior vice president and research director at the Federal Reserve Bank of Atlanta

August 19, 2009 in Business Cycles, Economic Growth and Development, Federal Reserve and Monetary Policy | Permalink

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Comments

Call me crazy, but I think this thing will turn and do so fast. We'll be busy again soon. But after that initial buzz, I don't know.

Today people are so connected and capital networks and social networks stronger than ever in world history. That is a factor not included, even in 01-02. Let's see if I'm right.

Posted by: FormerSSResident | August 20, 2009 at 07:07 PM

Turn good that is, from above.

Posted by: FormerSSResident | August 20, 2009 at 07:08 PM

Wow, and ouch. What a lot of puts and takes. Forgive me if the old quote about sound and fury signifying little occurs but nice to see all the different approaches. Reading thru them all just now it seems to be that the semi-traditional methods still seem to work and have been more accurate empirically. What Menzie calls a PDF/New Keynsian approach reflects in the CBO, FRB and IMF/WB estimates. Given that Menzie's last post which shows the IMF projections where GDPpot drops to 1% in 2010 and barely climbs back to 2% by 2015, with unemployment not reaching its speed limit until 2016 seems like the defensible position. ???
You might want to look at John Hussman of Hussman Funds take as well:
http://www.hussmanfunds.com/wmc/wmc090817.htm

It also seems to me a brute force approach would look at CalculatedRisk's work on comparing this to prior downturn's employment where this is deep and slow and "flipping" it around in a mirror image (an algebraic rotation)would also suggest "breakeven" in 2016.

Taken all together and reflecting Pres. Lockhart's view it would seem we're in a painfully slow and low recovery for most of the next decade.
Comments, reactions, correction ? Please tell me I'm wrong.

Posted by: dblwyo | August 20, 2009 at 07:13 PM

The economies capacity to supply is not a problem. Productivity growth was remarkable in the second quarter. The amount of unused productive resources is staggering. Capacity utilization is 12.4 points below its 1972-2008 average. Returning to the 64.3% employment/population ratio of 1999-2000 would necessitate an 11+ percent increase in private sector employment in just two years (or a 13% increase in three years).

Getting back to full employment is a challenge, but not impossible. Four times in the last 70 years, private sector employment has grown by more than 11 percent in just 24 months. Three of them were war related: entry into World War 2, demobilization after WW2 and entry into the Korean War. The peace time example was from January 1977 to January 1979 when private employment rose 11.5 percent. This two year period also set a 50 year record for percentage increase in total hours worked in the non-farm economy and for increases in the employment-population ratio.

What caused such remarkable growth in 1977 and 1978? Answer: a generous TEMPORARY Federal tax credit for increases in employment above 102 percent of the firm’s employment.level in the previous year

The Democratic Congress elected in 1976 arrived in Washington at a time of high unemployment, anemic (3.4% during 1976) employment growth and rising inflation due to the quadrupling of world oil prices in 1973-74. It responded with a temporary New Jobs Tax Credit (NJTC) for 1977 and 1978 that lowered the marginal cost of expanding a firm's workforce by roughly 15 percent on average (more for low wage and high turnover firms). Despite foot dragging by the IRS, one third of the nation’s private employers received NJTC credits that lowered their 1978 taxes by $3.1 billion. By the final quarter of 1978, capacity utilization had spiked, real output had increased 15 percent and unemployment had dropped from 7.8 to 5.9 percent.

The expiration of the NJTC at the end of 1978 did not unravel these effects. During the next 12 months, output and employment continued to grow albeit at a slower pace and the employment-population ratio and unemployment rate were stable.

The later 1980 and 1982-83 recessions were caused by the 160% increase in oil prices precipitated by the Iranian revolution & the Iran/Iraq war and the Federal Reserve response to inflationary consequences of the oil shock.
http://digitalcommons.ilr.cornell.edu/articles/242/

Posted by: John Bishop | August 22, 2009 at 06:50 PM

Perhaps this discussion is too macro. A good chunk of our unused capacity is capacity to build more housing--when we already have a substantial excess supply. (Data here: http://www.census.gov/hhes/www/housing/hvs/hvs.html). Getting that unused capacity productive again would not make us a wealthier country, it would only make us a more-over-supplied-in-housing country.

Some of the resources used to create this productive capacity need to be redirected to other sectors, but some of the resources are so specialized (backhoes, nail guns, chop saws) that they may rust away before they are needed again.

This suggests that meaningful capacity is lower than currently measured, our output gap is less, and the room for a rebound is less.

Posted by: Bill Conerly | August 23, 2009 at 01:01 PM

As a business writer, I hope the economy is improving. In the 30-plus years I have been reporting on small business topics, I have never witnessed more devastation in the marketplace. It is a Hurricane Katrina out there. What small business needs is a big infusion of credit to jump start the market. Credit has been cut off to businesses through no fault of their own. To cite just one example, a contractor had a $500,000 line of credit reduced to zero over night. Following that he laid off staff members. This sector of the economy is in desperate need of help. The big banks received help, now it is time to help the little guy.

Ron D

Posted by: Ron Derven | August 25, 2009 at 11:03 PM

the difference between potential and actual output, the so-called output gap...f the output gap is closing faster because of a drop in potential, policymakers might decide to increase interest rates a little earlier and a little higher to prevent inflation from rising...great help..learn a lot..people should know about this..

Posted by: Repair Credit | June 22, 2010 at 07:26 AM

You've said that the recession to the economy may end, but how could you say that when it's not yet that stable?

Posted by: Build Credit Fast | August 02, 2010 at 05:03 AM

how could you say that when it's not yet that stable?

Posted by: Credit Repair Services | August 25, 2010 at 09:13 AM

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