Don't look now, but this New Economy may not be all it's cracked up to be.
To the joy of New Era believers, economists are starting to seriously entertain the notion that the economy's speed limit is higher than previously allowed. But in an unexpected twist for that same camp, they're also pointing out that interest rates may be headed higher because of that new speed limit.
Spikes in productivity, the long-awaited fruit of information-technology investment, are getting increasingly difficult to ignore. The third quarter's 4.2% rise in nonfarm business productivity was just the latest in a fairly consistent string of solid gains over the past couple of years. And that impressive chain of data has a lot of dismal scientists raising, by as much as a full percentage point, their estimates of how fast the economy can grow without producing inflation.
"People are now of the opinion that sustainable growth is somewhere in the 3%-to-3.5% range," says Paul Kasriel, chief U.S. economist at
Northern Trust Co. of Chicago
. "That's a mainstream view of things. Of course, there are others who think that we're still underestimating productivity growth. But my view is that the
is probably thinking somewhere in the 3%-to-3.5% range."
Sustained productivity gains are the bedrock of the New Era, of course. If more goods and services can be produced by the same number of workers in the same amount of time, then total production can grow without attendant increases in unit labor costs or, further down the road, price inflation. Naturally, the Federal Reserve needn't raise interest rates to slow the economy, for, courtesy of productivity, there's more than enough slack in the economy.
Quite a rose garden, to say the least. But there's another line of thinking that says the Fed may actually need to raise rates in a high-growth, high-productivity economy.
Higher Speed Limit Gooses Real Rates
One economist who has been writing a fair amount about the economy's speed limit lately is Richard Berner, chief U.S. economist at
Morgan Stanley Dean Witter
. In a note last week, Berner wrote that "a higher-productivity growth economy, characterized by strong investment and credit demand, is likely to push the level of real interest rates higher than previous 'norms' of 3%."
To begin with, because real interest rates are nominal rates minus inflation, low inflation automatically raises real rates. And periods of high growth and high productivity can create intense credit demand, as people leverage themselves to capitalize on economic booms. That can put upward pressure on interest rates.
More importantly, though, such periods are characterized by rising returns on investment. It's a nifty little phenomenon, and one most clearly seen in the U.S. stock market: Investments in information technology, largely financed by borrowing, raise productivity. That, in turn, boosts profits, which in turn increase valuations. Ultimately, the argument goes, such periods will cause people to look for similarly higher yields on all investments, including loans.
Mark Vitner, vice president and capital markets economist at
, puts it another way. "The economy's long-term growth rate potential
the real rate of interest," he explains. "It's called opportunity cost. If the economy's sustainable growth rate is stronger than what people thought, then the opportunity cost of holding idle cash is greater. That's something that a lot of people are just waking up to."
If the economy's speed limit is higher than previously thought, therefore, so are real interest rates. To Berner, who thinks the speed limit may have increased by 75 basis points, that means Fed policy is still too accommodative, given the intense growth in the economy. "While real rates are higher, they need to be higher," he says. "And you need still-higher rates to slow the economy."
He's not alone. Significantly, Fed Gov.
argued as much last night in his
speech before the
Stern Graduate School of Business
Monetary policy would have to be alert both to the effect of a higher productivity trend on demand as well as supply and to the implication of the model that an increase in trend productivity raises the economy's real equilibrium interest rate. Therefore, even under the permanent-bliss story, policymakers have to be alert in the short run to the possibility of overheating and, at over a longer run, to aligning the real federal funds rate with its higher equilibrium value.
This may all be a bit academic, however, given that the present growth rate -- a rabid 5.5% in the third quarter, by the
last reckoning -- outstrips even the most generous estimations of the economy's speed limit, whatever it may be exactly.
"You'll know when the economy is exceeding its speed limit," says John Lonski, vice president and senior economist at
Moody's Investors Service
. "That will be when prices will grow out of control."
It's safe to say the Fed won't want to wait that long.