The Fed's big hole en route to Jackson Hole: getting out of its own way

By Brian Bethune

U.S. central bank needs to steer real interest rates down to the 2% range

The performance of the U.S. economy during the expansion until the first quarter of 2024 was astonishingly positive, either under an absolute basis or on a relative basis compared to other major advanced economics. Real GDP grew at an average annual rate of 2.5% through the first quarter of 2024. That is about a half a point higher than potential output growth estimated by the Congressional Budget Office in its June 2024 economic projections. In Olympics terms, it's an economic gold medal.

Business-sector productivity grew at an average annual rate of 1.75%, about half a percentage point above pre-COVID trends, and consequently labor costs grew at a moderate average annual rate of 3.2%, well below the average annual increase in the personal-consumption expenditure prices of 4.4%. Productivity took a quantum leap upwards in 2020, held those amazing gains in 2021, retreated briefly during the first half of 2022 as the business expansion took a breather, and then reaccelerated in 2023-2024 to reach new record highs. Another economic gold medal.

Yet recently a considerable amount of confusion has been created by reports of a rapid and worrying "acceleration" in the U.S. economy in the second quarter of 2024, immediately followed by reports that the economy is teetering into a sharp downturn and recession in the second half of 2024. It's a like a "recession mantra," which actually was repeated close to 9,200 times in one prominent financial publication during the current business cycle.

Neither of these reports is in fact consistent with the facts of the economy.

The underlying demand trends in the economy did not accelerate in the second quarter of 2024. Overall, private demand in the U.S. cruised along at an average annual rate of 2.6% in both quarters. However, due to the strong growth of imports consequent from high U.S. interest rates and a strong U.S. dollar, demand for U.S. products and services expanded by a more modest 1.8% in the first quarter and 2.0% in the second quarter. Demand did not break out here.

Fluctuations in overall production in the U.S. in the first half of 2024 were impacted by large swings in inventories, with a decline in inventories in the first quarter offset by a large increase in inventories in the second quarter. Fluctuations in inventories add data noise that can distort the overall real GDP quarterly patterns immensely - that is nothing new.

Consistent with the deceleration in demand for U.S.-produced goods and services, there has been a trend decline in the monthly rate of private-sector employment in the first half of 2024, with those employment gains falling below 100,000 in July.

Which brings us back to the fundamentals of a healthy economy: productivity. In the second quarter of 2024, nonfarm business productivity actually accelerated to 2.3%, and labor costs rose by only 0.9%.

For the U.S. economy to generate these productivity gains it needs to grow, on a production basis, by at least 2.25%. This is one of the many benefits of a contemporary "high-pressure" economy: productivity accelerates, labor costs remain contained, employment for minorities and others increases. Growth is your friend.

With the acceleration in productivity in the second quarter, the U.S. economy is fundamentally in a good position to continue to grow at near- or above-potential rates. Our projection for real GDP growth in the third quarter is in the range of 2% to 2.5%, or close to the threshold for another positive quarter for productivity in the range of 1% to 1.5%, which in concert with slowing wage growth will keep the disinflation process intact.

Producer prices rose by less than 0.1% in July. Consumer prices rose by less than 0.2% (0.15%) in July. And yearly consumer-price inflation dropped to only 2.9%. Excluding problematic shelter costs, which are related to long-term structural imbalances in demand versus supply of housing, CPI inflation dropped to 1.7%. This is further evidence that the economy continues to crank out productivity magic in the third quarter.

The main potential risk to these growth and productivity trends in the second half of 2024 is that the Federal Reserve allows real interest rates to march higher from already elevated levels. Short-term fed-funds-based real interest rates are now 3%, and borrowing spreads paid by consumers and businesses above and beyond that level have increased since the Fed embarked on its tightening cycle in March 2022. With the key personal-consumption deflator projected to notch down to about 2.4% in July and 2.3% in August, the real-interest-rate vise on the economy will continue to tighten.

The most egregious consequences of rising real interest rates fall mainly on the employment and income distribution. Unemployment rates for minorities have already risen by 1.5 percentage points from the post-COVID cycle trough, and for marginally attached workers the unemployment rate has risen by 1.1 percentage points. High real interest rates transfer purchasing power from lower-income quintiles, where relatively more credit-card and student debt has been assumed by low-income households, to higher-income quintiles that have accumulated the bulk of COVID-cycle excess savings in money-market accounts.

In short, high and rising real interest rates are regressive in terms of both employment conditions and the distribution of household net worth. This is not a potential or a fiction - it has already happened in the past year and a half. The balance of risks has shifted decisively, with enormous consequences.

The Fed has abandoned the policy tiller and strapped itself to the mast in the face of these economic, productivity, employment and income-distribution sirens. Fortuitously, in anticipation of prospective Fed easing, long-term rates have already descended by about 60 basis point to near 4%, which will bootstrap the expansion to some extent.

The risk is that the economic ship, healthy as it is, will be sandbagged by high real interest rates, and then runs aground. If the threads of economic and social prosperity start to unravel, that will provoke yet another fiscal expansion. It's long overdue time for the Fed to return to the policy tiller and steer real interest rates down in line with the potential growth of the economy near 2%.

Brian Bethune is a professor of economics at Boston College.

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-Brian Bethune

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08-19-24 1534ET

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